Capital Ideas^™ 
Investment insights from Capital Group

Falling interest rates present challenges and opportunities. Could economic growth in the United States continue or even accelerate? Or could a crisis knock the economy off its path?

Investors wrestled with similar questions while the U.S. Federal Reserve raised rates. Although there were bouts of volatility, a strong consumer and megatrends such as artificial intelligence (AI) powered equity markets to new highs. The S&P 500 Index gained 36.35% for the year ended September 30, 2024.

Bonds, meanwhile, have reasserted their status as income generators and diversifiers, with the Bloomberg U.S. Aggregate Bond Index up 11.57% over the same period in U.S. dollar terms.

The lesson? Don’t let uncertainty get in the way of your long-term investment goals. Here are five opportunities to consider as the Fed lowers interest rates.

1. SMID-cap stocks may be poised for a comeback

Companies with a market capitalization of US$20 billion or lower — so-called SMID-cap stocks (small and mid cap) — are likely beneficiaries of declining borrowing costs. This may be especially true if a healthy economy persists.

“Falling interest rates tend to benefit some SMID-cap companies such as those in the biotechnology sector, and I think there could be a broadening away from a handful of technology stocks,” says equity portfolio manager Julian Abdey. “Valuations are attractive right now for SMID caps, though investors have to be selective.”

There are also SMID-cap companies integral to the AI boom, particularly in the industrials sector, thanks to the intense energy needs of the data centres required to power AI. Hammond Power Solutions, which manufactures dry-type transformers in various sizes that are used in data centres, is one example.

Modine Manufacturing has also benefited from the build-out of data centres. The company makes chillers, fan walls, coolant distribution units and other systems designed to prevent overheating. Explains Abdey, “They have won business with the hyperscalers because their products are considered more energy and water efficient.”

The re-industrialization of the U.S. and reshoring of U.S. supply chains resonate with Abdey. “For example, Enerpac is viewed as the leader in high pressure hydraulic tools essential for construction and manufacturing. They have an excellent CEO who is focusing on improving returns for shareholders and making small-scale mergers and acquisitions (M&A).”

Lower interest rates could encourage more companies to go public as competition for investor cash declines. “The market for initial public offerings has steadily improved this year, and I expect more companies in the small- to mid-cap size to initiate offerings in 2025.”

2. Falling rates could boost dividend-paying companies

Investors seeking a more defensive portfolio may want to consider dividend-paying stocks, says equity portfolio manager Justin Toner.

“Investors have focused less on dividends recently because stocks have jumped so much, but dividends historically have been a meaningful contributor to stock market returns.”

Hallmarks of durable dividend-paying stocks include companies that have strong cash flow and prioritize capital allocation. Gilead Sciences, a health care company known for its HIV drug therapies, has shown a commitment to growing its dividend. In addition to its core HIV franchise, the company has also expanded into cancer therapies.

Toner notes that certain commodities companies also tend to focus on capital allocation versus M&A, even as the price for their product jumps. For example, Lundin Mining is viewed as a conservative company that does not borrow heavily to grow its copper mines compared to its peers.

Could Fed rate cuts lead to a U.S. housing boom? While mortgage rates have declined from their peak to around 6% currently, the U.S. is unlikely to revisit the pandemic-era level of less than 3%, according to Cheryl Frank, equity portfolio manager. “I don’t foresee another big housing cycle for a while since most Americans have mortgages well below the current rate.”

Against that backdrop, homeowners are incentivized to repair or improve an existing home rather than move. Rising mortgage rates slowed housing activity post-COVID, and many companies involved in the housing supply chain have experienced weak sales. “As we start to see growth off this low base, some of these companies may do better,” Frank says.

For example, Home Depot CEO Ted Decker said during an earnings call in August that “as [mortgage] rates head down towards 6%, we would expect to see some activity,” when asked at what level mortgage rates need to be to drive the company’s business higher.

Meanwhile, Carrier Global, known for its HVAC products, reported increased revenue and margin expansion during its most recent second quarter earnings. Building materials company TopBuild has similarly continued to grow its business.

3. Economic tailwinds support corporate and high-yield bonds

Bonds issued by companies across the ratings spectrum offer solid income potential. What’s more, default rates are likely to remain low and bond prices could appreciate as the Fed lowers rates.

Companies have broadly reported healthy earnings, and their debt levels are reasonable, says Damien McCann, portfolio manager for Capital Group Multi-Sector Income Fund™ (Canada).

Many companies, particularly those rated high yield, locked in low borrowing costs during the pandemic when rates were near zero. They’ve subsequently operated their businesses as if the economy could slow as the Fed raised rates, with several upgraded to investment grade (rated BBB/Baa and above) over the past year. As a result, the default rate expectations for both investment-grade and high-yield bonds are low.

“Credit fundamentals remain stable, and valuations are where I’d expect them to be in an environment where the outlook for growth is positive,” McCann says. Although the optimism is largely reflected in bond prices, investors can still benefit from the higher yields offered by corporate investment-grade and high-yield bonds compared to U.S. Treasuries.

Starting yields have been a good indicator of long-term return expectations. The Bloomberg U.S. Aggregate Bond Index, a widely used benchmark for investment-grade bonds, yielded 4.5% as of October 10, 2024. The Bloomberg U.S. Corporate High Yield Index, a broad representation of high-yield bonds, yielded 7.25%.

4. Long live the 60/40 portfolio

Whether it’s the calm before the storm or clear skies ahead, the Fed’s rate cutting cycle is a good time for investors to review their portfolios.

The classic 60% equities and 40% bonds portfolio has rebounded after a rough 2022, when both equities and bonds declined amid rate hikes to combat inflation. While the exact allocation may shift, a diversified portfolio is typically intended to generate solid returns while minimizing risks.

Now that inflation is closer to the Fed’s 2% target, officials have more flexibility to lower rates to find the neutral policy rate that neither restricts nor stimulates economic growth, says fixed income portfolio manager John Queen.

With bonds offering higher income potential today, Queen believes investors may be able to take on less risk while still meeting their return expectations. Additionally, should growth deteriorate markedly, it’s reasonable to expect a high-quality core bond fund to offer diversification benefits as the Fed would likely swoop in and cut rates beyond the current market forecast.

5. Money market funds may lose their lustre

The spectacular rise of assets in money market funds has been well-documented in the U.S. Total U.S. money market fund assets as calculated by the Investment Company Institute stood at US$6.47 trillion as of October 10, 2024. But now that the Fed has lowered interest rates, investors may want to weigh other options. That’s because returns for money market funds are expected to decline to below 3% in 2025 — a level that generally leaves investors looking elsewhere for stronger return potential.

Queen doesn’t want investors to turn a blind eye to risks, however. A balanced investment strategy isn’t just about deciding how much to allocate to equity or bonds. The risk-reward potential for stocks and bonds varies, so it’s important to know which specific company or security is in a portfolio.

“I prefer to take a long-term and flexible approach to investing. This means being mindful of valuations and adjusting my investments over time depending on where our analysts and portfolio managers see value. Not every idea is a great investment, but The Capital System™ allows for a lonely investment idea to shine,” Queen says.