V2U Research

The Federal Open Market Committee (FOMC) reduced its benchmark interest rate by 50 basis points, or 0.50%, on September 18, 2024. Since it was the first rate cut since March 2020 and the first rate change since July 2023, the action garnered media attention.

The U.S. economy was improving, which led to the cut. The Fed's rate hikes in 2022 and 2023 were fuelled by inflation, which dropped below 3% in July 2024 and then again in August and September of the same year. Most investors anticipate a string of rate cuts from now until mid-2025 as inflation approaches the Fed's long-term goal of 2%.

Investors' main concern is how their investment plans and portfolios may be impacted by these decreased rates. Let's examine the normal reaction of the stock market to declining interest rates in more detail.

The economic impact of rate reductions

Interest rates on lending to consumers are lowered by banks when the Fed lowers interest rates. The cuts are instantaneous for current variable-rate debt. Lower recurring interest costs in this scenario are immediately advantageous to both commercial and consumer borrowers. There is no impact on existing fixed-rate borrowings, but new fixed-rate loans also become more affordable. On the other hand, decreased interest rates may make it possible to refinance fixed-rate loans.

In other words, rate reductions make borrowing less expensive. Cheaper debt generally benefits businesses, but investors' and company executives' reactions depend on the rationale behind the rate cut.

Rate reductions when the economy is becoming better

The reaction should be favourable if the Fed reduces rates due to a slowdown in inflation. Companies will probably work harder to expand. Investors may put more money into the stock market if they anticipate bigger earnings in the future. Stock prices may rise as a result.

Rate reductions when the economy is contracting

When lower rates are brought on by a slowdown in the economy, the stock market may suffer. Investors and company executives may be more hesitant to make growth investments when the economy is uncertain.

"Historically, equities perform significantly better when the Fed is lowering rates rather than when the Fed is raising rates," said Robert R. Johnson, CEO and head of Economic Index Associates, a company that develops active index strategies.

Timeliness and expectations of investors

Stock prices are significantly impacted by investor expectations. Because of this, the impact of a rate change typically starts well before the Fed takes action. Stock prices increase when investors anticipate a rate cut and the economy is doing well.

After the Fed makes the cut, there may not be many consequences. If the rate cut is more or less aggressive than investors had anticipated, that is the exception. The market can then move once more as investors adapt to the new situation.

Businesses that gain when interest rates decline

Autos, clothing, and retail are the best-performing industries when interest rates are declining. Additionally, We sees potential in REITs, or real estate investment trusts, especially mortgage REITs.

With rates expected to continue to fall in 2024 and beyond, both equity REITs and mortgage REITs could be attractive investments.

Investors with short time horizons

Investors may recognize the chance to modify holdings in accordance with the interest rate environment if they need to optimize income or growth in a comparatively short period of time. This usually entails alternating between stock and bond exposure. When interest rates are rising, bonds are preferred, and when interest rates are falling, stocks gain popularity.

Investing for the long term

"Emotional decision-making resulting from reacting to rate variations can impair long-term performance.

Longterm investors may depend on shifting market conditions to force them to periodically reassess the asset allocation or composition of their portfolio. Few or no changes are required if the allocation is operating well and the risk profile is acceptable.

However, as interest rates fluctuate, a tried-and-true allocation technique might permit minor adjustments to enhance performance.

Investors may decrease their banking and utility holdings while boosting their exposure to industries that have historically performed well in declining interest rate environments, such as retail, clothes, and automobiles, when interest rates are predicted to decline over time.

Without altering their relative exposures to more general asset classes, such equities, bonds, and alternative assets, investors can make sector-based modifications. By doing this, the risk and appreciation potential of the portfolio should remain relatively steady, which is essential for long-term growth.

Profiting from declining rates

Over the next six to eight months, interest rates may be lowered one after the other if the economy keeps improving. As a result, regular traders can prefer to make larger stock investments rather than bonds. Smaller sector tweaks that don't interfere with their current, tried-and-true allocation techniques can be advantageous to long-term investors.