The Federal Reserve (Fed) has indicated a potential pause in interest rate hikes and the futures market suggests cuts might occur in early to mid2024 if inflation continues to ease. As the consensus shifts towards interest rates currently being at their peak, attention turns to investments that historically perform well when the Fed starts to cut. Stocks, particularly growth stocks and small caps, tend to outperform as rates reach their top. Fixed income prices rise when yields fall, and the real estate sector may gain as financing becomes more affordable. Falling rates tend to be good for assets in general. As Warren Buffett says, “any investment is worth all the cash you’re going to get out between now and judgement day discounted back.” Discounted back means adjusting future cash to its present value using interest rates. Lower rates mean future cash has more value today and justifies higher valuations. However, the initial recovery in growth stocks and small caps often delivers the largest outsized returns when interest rates peak.
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It is important to clarify that the rate cuts, in our view, would not be indicative of economic weakness but just part of policy normalization. With inflation expected to drift below 3%, the real interest rate, which excludes the impact of inflation, increases. The Fed is expected to trim rates to correct for this as inflation moderates, hopefully delivering a soft landing, assuming everything goes according to plan! Policy normalization is not happening in a vacuum. Rather there are other forces at play like falling inflation, global conflicts, and still healthy consumer balance sheets. With that in mind, we think about the sectors and asset classes that may benefit from falling interest rates.
- Small Caps – Smaller businesses often rely more heavily on borrowing for growth than larger corporations. Small cap companies can also exhibit greater sensitivity to macroeconomic and inflationary factors. As interest rates and inflation moderate, the landscape for small caps looks much brighter.
- Growth Stocks – Investors are drawn to growth stocks because they see an attractive stream of cash flows in the future. The cash generated in the future is ascribed a valuation in the present using a discount rate that is based on prevailing interest rates. As rates decline, valuations should increase, all else equal.
- Fixed Income – In a falling rate environment, fixed-income tends to excel though generally not as much as equities. Many investors, anticipating that rates have peaked, are extending their bond maturity profile by purchasing intermediate-dated bonds. The emphasis is on intermediate, rather than longer-dated bonds, because as the yield curve normalizes rates will likely fall more on the short end.
- Real Estate – While correlated with interest rates, the real estate sector is highly influenced by the strength of the economy. Falling rates may aid a housing market in need of affordable inventory or benefit commercial borrowers in need of refinancing, but the outlook for the sector is more closely aligned with the domestic economy.
The anticipated policy pivot by the Fed should favor most asset classes, with growth stocks and small caps delivering the best performance as rates peak and begin to decline. Additionally, this juncture presents an opportune moment to revisit the basics of bond investing. For portfolios that have maintained very short maturity profiles in fixed income during the period of rising rates, a strategic return to a neutral stance could be prudent. Ultimately, the prospect of a pause in rate hikes, coupled with the potential for cuts in the near future, positions the economy for a soft landing and has positive implications for investors.