Interest rates

Where to consider investing as interest rates fall

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 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.

 

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 $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 Julian Abdey, a portfolio manager with SMALLCAP World Fund® and The Growth Fund of America®. “Valuations are attractive right now for SMID caps, though investors have to be selective.”

The market rally may broaden to SMID-cap stocks

Sources: Capital Group, MSCI. Relative P/E (price to earnings) ratio reflects the ratio between the forward 12-month P/E ratios of the MSCI ACWI SMID Cap Index and the MSCI ACWI Large Cap Index. Annualized standard deviation (based on monthly returns) is a common measure of absolute volatility that tells how returns over time have varied from the mean. A lower number signifies lower volatility. As of September 30, 2024.

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 centers required to power AI. Hammond Power Solutions, which manufactures dry-type transformers in various sizes that are used in data centers, is one example.

 

Modine Manufacturing has also benefited from the build-out of data centers. 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 Justin Toner, portfolio manager for The Income Fund of America® and CGBL — Capital Group Core Balanced ETF.

 

“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.”

Dividends stocks could offer defensive edge

Sources: RIMES, Standard & Poor's. As of September 30, 2024.