To combat inflation, the Federal Reserve increased interest rates by 5.25 percentage points since March 2022. The recent hints from the Fed about potential rate cuts in 2024 suggest a significant shift in interest rate expectations. As the Fed forecasts a possible reduction of three-quarter points to around 4.6 percent by year-end 2024, the landscape for investments is evolving. Anticipating this change from rising to decreasing interest rates for the first time in a long time, I’m personally evaluating optimal strategies to deploy some cash-equivalent positions.
While there is no surefire way to time investments for when interest rates begin to decline, there are a few options that can lower your risk and position your portfolio for future benefits in the coming months and years should interest rates fall. Here are four asset classes that tend to perform well in falling interest rate environments:
- Bonds and Treasuries
These assets often excel in declining rate scenarios due to their fixed interest rates. As interest rates drop, bond prices rise, offering opportunities for potential gains. For instance, if you purchase a 30-year Treasury bond yielding 4% and rates fall to 3%, the market typically values your higher-yielding bond at a premium. Thus, you may want to just ride out the duration of your bond and earn above-market income or sell your bond, recognize your capital gains, and invest your cash elsewhere.
- Real Estate
Lower borrowing costs generally stimulate demand in real estate markets. Reduced mortgage rates enhance affordability, potentially leading to increased property values and market activity, benefiting residential, commercial properties, REITs, and real estate funds. However, economic factors like supply constraints, regional affordability issues, and speculative behaviors might counterbalance the effect of falling rates on home prices.
- Preferred Stocks
With fixed dividends, preferred stocks offer stability. They are a type of hybrid investment that function as a stock and, similar to a bond, pay a fixed dividend. Preferred stockholders have preference over common stockholders if a company is unable to pay its dividends, and preferred stock returns are often higher than those of regular stock. In falling rate environments, the appeal of consistent income typically results in higher demand for preferred stocks and when demand is higher, prices typically increase.
- Growth & Technology Stocks
Certain sectors, like technology, often thrive with reduced borrowing costs. Growth stocks within these sectors may experience amplified growth potential and higher valuations. Lower rates can lead to increased spending and borrowing, positively impacting these stocks. In addition, in discounted cash flow valuation models, lower interest rates have an adverse effect on the present value of future profits. The predicted future profits of growth stocks are usually substantially higher than the current profits resulting in a higher present value when interest rates or discount rates are lower.
Risk Considerations and Diversification Strategies
While these asset classes historically perform well in falling interest rate scenarios, it’s vital to consider associated risks. Recognizing and managing risks associated with falling interest rates involves a comprehensive understanding of various risk factors and employing diversified strategies tailored to an investor’s specific financial situation and goals. Economic conditions, geopolitical events, or unexpected market fluctuations can also influence asset prices.
Diversifying across asset classes such as equities, fixed income, real estate, and alternatives helps spread your risk. A mix of assets with varying correlations to interest rate changes can also help mitigate the impact of rate movements on the overall portfolio. You may also want to diversify within each asset class. For example, within real estate, diversification might include different property types or geographic locations to spread risk further. Within fixed income, diversification by bond quality (government, corporate, high-yield) and maturity (short, intermediate, long-term) would help further manage interest rate risk.
Conclusion:
In the evolving landscape of interest rates, exploring diverse investment options presents potential opportunities. Understanding the nuanced dynamics driving each asset class in declining rate environments and effectively managing associated risks are vital aspects of strategic investing.
While experienced investors may navigate these shifts independently, seeking advice from a financial advisor is a recommended avenue for gaining professional insights and perspective. EsqWealth offers tailored strategies and informed perspectives, benefitting not only those seeking additional guidance due to limited expertise but also individuals desiring a comprehensive evaluation or lacking the time to dedicate to extensive research.
Consulting with a financial advisor allows investors to tap into their expertise and gain a broader understanding of market nuances, potentially enhancing their investment decisions. While not imperative for all investors, seeking advice from a financial advisor remains a prudent choice for those looking to further refine their investment strategies and gain professional insights into navigating the evolving interest rate environment.
