2024 Fed Rate Cuts: Portfolio & Investing Ideas

By Keith Heng, 18th June 2024

As a September Fed rate cut grows increasingly eminent, now is an apt time to look at portfolio & investment strategies to capitalise on a lower rate environment.

General Investment Strategy

(1)        Cyclical Stock Sectors

Historically, falling interest rates exceptionally benefit cyclical sectors, such as real estate, consumer discretionary or technological sectors. Companies like Tesla, Adidas, and Home Depot, selling non-essential goods and services tend to be more exposed to rate cuts which fuel discretionary purchases. On the other hand, the real-estate and technological sectors are heavily financed and capital-intensive, disproportionately benefiting from rate cuts.

 Note: General 12-month post-rate cut odds per cyclical industry computed by Fidelity considering top 3,000 stocks by market capitalisation, since January 1970

Source: Charles Schwab

(2)        Utilities Sector

Utilities stocks are defensive by nature, competing with fixed-income products like short-term bonds that attract in high-rate periods. Low-interest environments and general economic slowdown make defensive sectors like utilities, with stable dividend and earnings, more attractive to investors. This could be stocks like WEC Energy, Edison International or Duke Energy.

(3)        Small-Cap Stocks

 Note: Data as of July 2024, using SRCH function on Bloomberg and includes corporate bonds and loan (tranches) and excludes financials.

Source: Apollo Asset Management

Falling rates provide balance sheet boosts for most stocks. This effect tends to be accentuated for small-cap companies that tend to hold more debt than larger companies. Historically, comparing the Russell 2000 Small-Cap Index with the S&P 500 since January 1970, small-cap companies outperform larger-cap companies 76% of the time in the 12 months after rate cuts.

(4)        Locking in Interest Rates with Long-Term Bonds

For the past two years, short-term yields have been the focal point of fixed income investments due to high rates. However, long-term rate cuts are now imminent and likely. Despite this, the market still reflects reluctance for long-term bonds given the relatively high short-term yield environment. Afterall, 6-month treasury bills are still above 5%, levels unseen since before the 2008 Recession. However, this is a good time to accept, and lock in ‘lower’ long term rates.

 Note: If the rate cut is conclusive, at least in the short to medium term, locking in long-term rates now can be beneficial as a cornerstone for portfolios moving forward into a period of cascading rates.

Source: Fidelity Viewpoints

With time on the Fed’s side and no present economic factors causing the Volcker-era rate fiasco – whether the 1st rate cut comes in September or December is irrelevant to the indication that long-term bonds are on their tipping point of attractiveness. With Fed indications at their most certain levels since 2022, speculative short-term yield betting has unprecedented risk of getting investors caught off-guard by declining yields.

Preparing Portfolio for Rate Cuts

Personally, I believe that now is an appropriate time to create a portfolio exposed to the premise of long-term rate cuts – either as a standalone investment strategy or to mitigate a broader, existing portfolio’s exposure to rate changes. The main risk of such a portfolio, from the perspective of a 12-month horizon starting from today, would be either – a rate hike, which goes against the premise of a rate cut, or that the premise holds, but comes much slower than expected (e.g. only one rate cut in the next 12 months).

The former risk of a rate hike is highly unlikely, given current market sentiment and economic data. Even with the most conservative interpretation, they only support maintaining rates at present-levels. Furthermore, effective rates were maintained at 5.3% even when inflation statistics were twice their current levels, making a rate hike unlikely even if inflation remains sticky.

However, the chance that rate cuts come much slower than market consensus (most believe the first cut to come in September this year), is highly plausible. In fact, short-term betting on Fed timing has historically been notoriously difficult.

Portfolio Recommendations

Here, I provide a general portfolio allocation strategy as an idea of how one might capitalize on lower rates. The portfolio described is intended to create low-risk, stable earnings as a diversification for existing investments moving into the lower-rate period. The allocation is of course, general, and needs to be adjusted based on specific investment goals.

 Note: General portfolio allocation to capitalise on potential rate cuts while limiting downsides in rate cut delays

(i)         A Mix of Long-Term & Short-Term Bonds

The benefits of purchasing long-term bonds now are manifold. With long-term rates expected to converge to roughly 3% over the next two years, they offer a chance to lock in low-risk, stable but relatively attractive returns over the next few years. Furthermore, they serve as diversification for the market volatility that ensues major rate cut events. The capital gains and high liquidity of such bonds following rate cuts also provide portfolio flexibility for prevailing market changes.

However, as aforementioned, it is probable that Fed rate cuts come slower than expected. If this scenario plays out, long-term bonds represent wasted opportunity. Thus, short-term bonds should be added to the fixed income mix. In the event of sticky inflation or even, rate hikes, they mitigate the lost returns locked in by longer bonds.

Thus, long-term bonds form the primary foundation of our interest rate portfolio. Even with the risk of premature buying, which is somewhat mitigated by shorter term bonds, their benefits over the longer, lower-rate environment are manifold. Here, we allocate 50% of the portfolio to bonds, with 35% to long-term bonds and 15% to short-term bonds.

 Note: 10-year Treasury yield rates quotes on investment basis. Quoting a research paper from Charles Schwab on why now is the time to lock in long term rates, ‘Hope is not an investment strategy. Rather than hope that the 10-year Treasury yield rises back to 5%, keep in mind that a yield of 4% hasn’t been seen in years prior to that’

Source: St Louis Federal Reserve

For long-term bonds, 5/10-year Treasury Notes or Investment-grade Corporate Bonds are a good option. For short-term bonds, since the primary market contention is that projections of a 1st rate cut by September this year might be too early due to sticky inflation in several PCE categories – 3-month and 6-month Treasury Bills offer good protection against sticky inflation.

(ii)        Limited Exposure to Small-Cap Stock Funds

The issue with betting on the growth of individual stocks based on how interest rates might improve financials is that such an effect, while conspicuous when looking at the aggregate of an industry (such as how rates affect the S&P 500), plays out vastly differently for individual unique companies. Anything from industry developments to national policy or company decisions could negate or enlarge the effects of rate cuts.

Thus, investment in individual cyclical or utilities stocks (as mentioned later) should be primarily based on sound fundamentals (even in the absence of rate cuts). Rate cuts are a mere embellishment and contributing factor – but not the sole or primary reason for any pick. This also mitigates the potential downside if rate cuts do not arrive as expected.

A good way, however, to bet on the general effect of rate cuts without drowning in individual stock picks is through small-cap stock funds. Indeed, one can even further increase their exposure by limiting their picks to technological or real-estate small-cap stock funds (the S&P 500 Information Technology tends to fluctuate even more than the S&P 500 in response to Fed news). However, this also greatly complicates the exposure to industry-specific developments beyond interest rates itself.

Note: Avantis US Small Cap Value ETF (NYSEARCA: AVUV) historical performance.

Source: Morningstar, Inc.

For instance, an interesting small-cap fund to follow is the Avantis US Small Cap Value ETF (NYSEARCA: AVUV). By itself, from a small-cap investing perspective, it is an excellent choice, substantially outperforming many small-cap and notable ETFs. Unlike passive index-tracking funds, AVUV combines indexing strengths, such as low turnover and efficient diversification, with active decision-making.

Rate cuts are likely only going to further inflate the performance of small-cap funds which have been depressed for the past two years. Another fund to follow with a longer history of promising returns would be the Vanguard Small-Cap Index Fund ETF (NYSEARCA: VB). Investments in 2-3 such small-cap funds would compromise 15% of the portfolio allocation.

(iii)       Good Cyclical Stock Picks with Potential Rate Cut Upside

As aforementioned, cyclical stock picks should be based primarily on undervalued opportunities. The potential upside from rate cut only serve to refine our selection; we want to make good picks whose value proposition includes but is not limited to rate cuts. This would form another 15% of the portfolio allocation.

One interesting company to follow would be the REIT Crown Castle Inc (NYSE: CCI). Owning over 40,000 cellphone towers and 85,000 miles of fiber, Crown Castle presides over highly secure cashflows from investment-grade clients like AT&T and Verizon. Since being overvalued in 2021, CCI has fallen over 50% to a contentiously low valuation (with rising rates exacerbating its business issues). However, with its enormous business footprint and scale, coupled by improving indicators (Q1 2024 performance was underwhelming primarily due to non-secular, one-time issues), CCI which offers a 6.5% forward dividend yield and undervaluation estimates of 25% to 30% is a good cyclical pick.

Another example would be Realty Income Corp (NYSE: O). Realty Income’s stock has fallen about 30% since its mid-2022 peak. However, its fundamental performance has been fairly constant when negating the effects of the rate hikes. The drastic fall is likely to be exacerbated by general sentiment surrounding the real estate sector. Furthermore, as a triple net-lease provider not heavily influenced by inflationary pressures, Realty Income has a defensive value proposition against a potentially softening economy. Rate cuts are likely to substantially improve company financials and bring about a much-needed price adjustment to a stock trading at roughly 30% discount with 6% yield.

(iv)       Defensive Utilities

Lastly, we will allocate 20% of the portfolio to defensive picks. In particular, we focus on Utilities companies – which likely face upward price pressure in low-rate environments but are also resilient to the broader economic factors that might affect our cyclical picks.

In particular, the artificial intelligence rally is likely to cascade into the Utilities markets as companies like Microsoft and Amazon dedicate more resources to building energy-intensive data centers. One example would be NRG Energy Inc. (NYSE:NRG), which boasts strong performances, is well positioned to capitalize on the expansion of data centers and is likely to further benefit from US energy regulatory developments.

Note: Constellation Energy Corp stock prices. Utilities are a traditional defensive pick. The recent AI rally has spilled over into certain utilities subsegments. However, the added upside means that AI/tech expectations are now priced into certain utilities sectors, requiring a re-evaluation of their 'defensiveness'.

Source: Constellation Energy

Another company that has captured market attention would be Constellation Energy Corp (NASDAQ:CEG). With a diversified business model spanning both nuclear and renewable energy options, CEG is expected to be one of the biggest beneficiaries of the AI craze. With the largest nuclear plant fleet in the US, which is essential for data centers that need 24/7 carbon-free generation, CEG is expected to be at the forefront of energy deals between Big Tech and the US energy industry. Strong existing performance, a unique position to capitalize on the AI rally, and beneficial regulatory makes CEG a potential long-term utility defensive pick.

Concluding Thoughts

Fed monetary policy is constantly evolving. Understanding its historical developments and present workings sheds insight into Fed mentality. Unlike the Volcker era, the Fed in 2024 has the economic allowance, and reason – to maintain a conservative approach. Current estimates place a 1st rate cut in September, though delays are probable.

There are myriad ways to capitalize on this rate transition. Personally, I believe the true value of this transitionary window is to secure stable, long-term returns into a prevailing climate of lower rates, political volatility and many unknowns. This forms a valuable diversification for existing investments moving forward.

My described portfolio aims to achieve this. Firstly, it places more emphasis on the general interest rate trend than precise short-term timings – mixing short-term and long-term interest rate products. Secondly, the primary goal is to lock in higher returns in the future low-rate climate as a form of stable, low-risk diversification. This explains the primary allocation to bonds. Thirdly, cyclical stock picks are influenced by, but not solely based upon rate cuts. Fourthly, we bet on the general economic effects of rate cuts through small-cap stock funds, but only to a limited degree. Lastly, we incorporate defensive picks in the form of Utilities stocks.

Riskier approaches exist. For instance, short-term speculation on precise Fed rate cut timings can be done through swap futures. Alternatively, the portfolio allocation I described can be modified in many ways to fit differing goals. Defensive allocation can be reduced with cyclical and small-cap allocations narrowed to more volatile picks to bet more heavily on the effects of rate cuts.

The Fed transition is likely to be a major investment theme over the next year. Returns on portfolios such as this can serve as a stable diversification for a broader portfolio. This is unless, investors are willing to bet heavily on rate cut effects or timings. This should be done with heavy caution, given that at that level, the effects of rate cuts are usually hard to ascertain from other price drivers. With that being said, I remain excited for the rate developments in coming months.