Some investment options in a rate cut cycle

The most anticipated, but hardest to predict, interest rate cut has finally happened. At its September meeting, the Federal Reserve decided to cut rates by 50 basis points in order to support the economy, particularly the labor market that has cooled in recent months.

This was a preemptive reduction, and the Fed cautioned against assuming that this measure determines the pace and extent of future easing policy.

This is a significant step. It is the first interest rate cut since the Fed embarked on its most aggressive rate-hike cycle in more than 30 years. It is also likely the start of a new rate-cutting schedule in the United States and the rest of the world. In the case of the latter, many non-U.S. central banks have waited for the Fed before embarking on their own rate-cutting cycles. These steps should begin to free the U.S. and global economies from this long period of high borrowing costs.

As is often the case, a new cycle can potentially signal a change in market dynamics, so investors should consider reviewing their existing portfolios.

Areas of opportunity

In a falling interest rate environment, several segments can benefit. One of them is investment grade (IG) bonds. IG bonds are generally defined as bonds with a lower default risk and higher ratings from rating agencies. They are typically rated at least Baa by Moody’s or BBB or higher by S&P and Fitch.

Currently, IG bond yields are at one of the highest levels in 15 years. Investors can still benefit from these returns before further rate cuts occur. Additionally, IG bonds can also help diversify portfolios during a recession, as investors tend to rotate some of their holdings into riskier asset classes like stocks to bolster their portfolios.

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Small and mid-cap stocks are another interesting area to consider. Often underappreciated and overlooked, small and mid-cap companies tend to rely on short-term borrowing, so lower rates are beneficial to their bottom line. We have also started to see their earnings accelerate at a time when large-cap companies are experiencing slowing earnings growth. A continuation of this trend would support returns for this group of stocks and boost their valuations in a declining rate cycle.

Another area to consider is global quality dividend stocks. These stocks tend to have dividend yields that are higher than the market average. Global quality dividend stocks, such as those in consumer staples or utilities, also tend to be relatively more resilient than broader stock markets, as these sectors tend to be less sensitive to economic conditions.

Closer to home, Asian equities could benefit. Rate cuts will likely lead to a weaker US dollar, and Asian equities have historically outperformed during periods of US dollar weakness. The US Fed’s rate-cutting cycle will also provide an opportunity for Asian central banks to begin easing their local monetary policies, which may provide additional support for Asian equities.

In Asia, dividend stocks, those with yields above the market average, are among the most attractive. In addition to their exposure to Asia’s long-term growth, these stocks also tend to offer attractive dividend yields, often above spot interest rates; their yields can become more attractive when interest rates fall. Companies in the region are also benefiting from growing regulatory support to implement shareholder-friendly policies, which could further increase dividend payouts over time.

Beyond examining sectors that are likely to perform well in a falling interest rate environment, investors should also review their portfolios to identify sectors that are likely to experience lower returns as interest rates decline. Examples include cash, deposits and money market assets. Holding these for an extended period could result in reinvestment risks and lower returns, and investors may want to consider reallocating some of their allocation to other high-quality investments.

The market expects further rate cuts through 2026, but the magnitude and pace of future rate cuts will depend on the US employment situation. The cycle is just beginning and investors must continue to be agile and vigilant.

The author is a client portfolio strategist at Fidelity International