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In this video, Chief Investment Officer Mark DiOrio, CFA discusses Interest rates being high since March of 2022, but now, they're finally coming down. That means it's time to rethink how we're investing. Mark talks through why the Fed has now decided to lower interest rates, and they walk through specific investments that investors often consider when rates are coming down.

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Transcript:

00:00:05 - 00:00:10
Mark
So very good to see you today. We get to talk through how to invest when interest rates are cut. Interest rates have been high since March of 2022, but they are finally coming down. That means it's time to rethink how we are investing.

00:00:18 - 00:00:23
Erin
But before we get into that, can you first explain why the Fed is now lowering rates?

00:00:24 - 00:00:31
Mark
Sure. Well, with the decline in inflation rate, the Fed actually had a little bit of room to reduce interest rates. And what they do is look at what's called the real rate, which is the current Fed funds rate minus the inflation rate. This chart here shows the difference between the black line and some of those colored lines. It hit about 3%, which is relatively high, going back the last 30 years. So this gave them a chance to reduce those interest rates more in line with where they were in July of 2023, which was about 2.5%.

They lowered them, reversing that last part of the interest rate hike. The expectation is another 25 basis point cut in November, and another in December. That’s the base case—further easing as we head towards the end of this year.

00:01:20 - 00:01:26
Erin
And of course, the concern is that if the Fed raises rates too much or too quickly, it could push the economy into a recession. When will we know if we have successfully avoided a recession?

00:01:30 - 00:01:41
Mark
They saw some weakening in the economy, particularly in the unemployment rate, which is one of their mandates—to keep us at full employment. The rule of thumb for full employment is around 5% unemployment. We’re below that, but they did see it rising. When the markets sold off in 2022 expecting a recession, a recession never came. So we had a rally in 2023 that continued into 2024, and the market's message suggests they don't see a recession, at least not appearing right now.

Data shows that once the Fed starts cutting rates, if a recession follows within a year, the market’s still up on average about 13%. Without a recession, it’s up about 15%. In other words, the market's moving ahead, potentially pulling the economy with it.

00:02:36 - 00:02:42
Erin
Were you surprised it was cut by half a point rather than a quarter?

00:02:43 - 00:02:48
Mark
I was, but in retrospect, looking at the data, it does make sense given where they're coming from. The recent inflation report showed a real Fed funds rate at the critical 3% level, similar to times in 2007 when issues developed from keeping rates high too long.

00:03:13 - 00:03:38
Erin
Let’s talk about investing when interest rates are on the decline. What’s the biggest difference?

Mark
The biggest difference is you have the Fed on your side. There are rules of thumb—don’t fight the Fed, don’t fight the trend. The trend is breadth, or the expansion of stocks participating in the rally, which we saw come back in the third quarter. When the Fed lowers rates, financial conditions become easier, allowing liquidity to flow freely. This has historically been supportive for markets overall.

00:04:07 - 00:04:24
Erin
A lot of people are talking about small-cap stocks right now.

Mark
Definitely. Two things are helping small-cap stocks as we look into 2025. The first year of the presidential cycle is typically favorable for small-cap performance. Small caps have underperformed, so there's value there compared to large caps, which are more expensive. They also benefit more from interest rate reductions, due to loans and borrowing.

00:04:57 - 00:05:24
Erin
And high-yield investments?

Mark
Usually, before a recession, you'd see lower credit quality—like triple-Cs—underperforming first. However, triple-Cs are stable and performing well, which takes the recession scenario off the table for now.

00:05:32 - 00:06:02
Erin
How about bond ETFs?

Mark
Historically, yields on the short end move before the Fed cuts. With cuts, short-term rates come down to meet current rates over the next few quarters, while yields on two-year, five-year, and ten-year bonds don’t move much, as they have already rallied.

00:06:04 - 00:06:15
Erin
What about preferred stocks?

Mark
Preferred stocks have both fixed and floating rate coupons. They act like bonds, generally benefiting from rate declines.

00:06:18 - 00:06:44
Erin
And real estate investment trusts?

Mark
REITs are interest rate-sensitive. Utilities are included in this category, and rate cuts historically support these sectors. Rate cuts could continue into 2025, supporting these investments.

00:06:47 - 00:07:15
Aaron
Related to housing stocks—how does the housing sector look?

Mark
The housing sector faces an undersupply of about 2 million units, unlike the oversupply before the global financial crisis. This shortage should support the housing market and housing stocks.

00:07:17 - 00:08:00
Erin
Anything else to keep in mind right now?

Mark
There are geopolitical factors, like the recent Middle East conflict, which could lead to turbulence. Oil’s risen to around $72 a barrel but isn't at problematic levels yet. Safe-haven assets may perform well, but I wouldn’t expect negative market returns; the Fed and the economy appear strong enough to counterbalance these issues.

00:08:02 - 00:08:06
Erin
Mark, again, thank you so much for your time today.

Mark
Great. Thanks, Erin.

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