Discussion of falling interest rates often triggers thoughts of the lower interest you'll have to pay on debt or the lower earnings on savings accounts and other short-term savings vehicles. However, equally important, is the impact on investments.
"Risk assets love when the Federal Reserve is cutting rates and there aren't too many signs of recession," said Brian Henderson, chief investment officer at BOK Financial®. "It's reducing the possibility of recession and earnings tend to go up."
Henderson was speaking during BOK Financial's Economic and Market Outlook call for the fourth quarter. You can watch the recording here. During the call, Henderson was joined by T. Wes Verdel, senior quantitative equity portfolio manager at Cavanal Hill Investment Management, Inc., and Mike Maurer, senior fixed income portfolio manager, also for Cavanal Hill. They spoke about what may be ahead for the U.S. economy, the outlook for further rate cuts and how financial markets may react.
Here are five takeaways from the discussion:
1. Inflation could still derail the Fed's plans to cut rates. As of their September meeting, the Federal Open Market Committee (FOMC) was anticipating cutting rates by another 50 basis points (0.50%) by the end of 2024, and then by an additional 100 basis points (1%) in 2025. The fact that they've started cutting rates before there are many signs of recession is good for economic growth and financial markets, but it also risks inflation rising again, Henderson noted.
The Consumer Price Index's (CPI) data for September has already raised some inflation concerns, as both CPI and core CPI, which excludes food and energy prices, surpassed economists' expectations slightly. September data for the Fed's preferred inflation measure, the Personal Consumption Expenditures Price Index (PCE), will be released Oct. 31.
One factor boosting economic growth—and also the potential for inflation to rise again—is the high amount of federal deficit spending, which both presidential candidates are likely to continue, Henderson said. "I think that the odds that inflation is not going to be able to hit the Fed's 2% target are increasing."
2. "Momentum" investing may have had its heyday for a while. From Oct. 2023 to June 2024, momentum-driven investment strategies "were the clear winner" in equity markets, with value, small-cap and low-volatility strategies lagging behind the broader market by a wide margin, Verdel said. Momentum investing involves buying rising stocks and selling them when you think they have peaked, as opposed to the traditional "buy low, sell high" outlook.
Enthusiasm around the development of artificial intelligence (AI) was one driver of this trend, with tech stocks such as Apple, Microsoft and Nvidia outperforming the S&P 500 over the past decade. Another momentum investing driver was optimism around GLP-1 medications, like Ozempic, which treat type-2 diabetes and obesity.
However, now some of that enthusiasm and optimism is dying down, Verdel noted. "My opinion at this point is that these are still technologies in their formative stages," he explained. "In the best-case scenario, both technologies could have a monumental influence on society. In a more realistic world, where the best-case outcome is a lower probability event or the changes happen slower than we expect, then maybe these stocks have gotten a little bit of ahead of themselves."
3. Equity market volatility may be ahead, and the riskiest stocks may underperform. The tide started turning in equity markets in the third quarter of 2024, with value, small-cap and low-volatility investment strategies starting to lead the broader market, while momentum-driven strategies trailed. Interest-rate sensitive sectors such as utilities and real estate were the best performers in the S&P 500 during the quarter, which Verdel said is the "obvious play" when lower rates became a reality.
Looking forward, falling interest rates will likely help stocks with higher dividend yields, Verdel said. Meanwhile, the types of stocks that make up momentum investing may change somewhat.
However, he doesn't expect a huge tide change. "I'm not suggesting that everything is going to change overnight. It just looks like conditions are right for us to see things evolve into a different paradigm," he explained. "There's still room for momentum to run, but I think the stocks that make up that style could be rotating to other areas."
4. Taking on higher credit risk may not be worth it right now. Although mortgage and student loan delinquencies remain relatively low, that's not the case for credit card debt and auto loans, which are signs of consumers' financial stress. Even so, this stress isn't being reflected in the bond market yet, Maurer noted.
"The credit market is not reflecting any growth concerns or any economic worries," he said. "It also indicates we're not being very well compensated for taking on that credit risk. You're just not getting a whole lot of extra yield. This means we would probably moderate what we're doing on the corporate side and look for potential opportunities in other areas of the market," he explained.
One area to watch is the commercial mortgage-backed securities market, but it's important to do extensive credit research, he cautioned. "These deals can be top-heavy with a couple of properties making up a large portion of the deal. The quality can also vary greatly from deal to be deal, depending on the location of the assets and the types, whether it's office buildings, malls, hotels or retail," he explained.
5. Enthusiasm over AI is affecting fixed income investing, too. Although people usually think of the "Magnificent 7" stocks in relation to AI, investing in data center leases is also becoming more popular. "As we all know, there's been a mad scramble to build data centers around the country," Maurer said.
"Typically, something like that would make us a little bit more nervous about a potential mania and overbuilt situation, causing leasing prices to be relatively uncertain and unstable," he continued. However, he doesn't see that happening yet because the number of challenges associated with data center operation, such as the immense power requirements, are limiting their growth.
In the meantime, "there's a nice illiquidity premium" into investing in data centers, Maurer notes.
Finally, experts say it's important to keep in mind that there's never just one factor impacting the investment environment—even headline news is just one factor of many.
"A lot of people are talking about what comes next now that there's been the first interest rate cut, but they're talking about it in isolation," Verdel said. "All of these issues—inflation, unemployment, government spending and economic growth—also play a significant role in how things perform, so only focusing on rate cuts could produce an incomplete picture."
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