How to Position Your Portfolio for Lower Interest Rates

Whether you're pleased or disappointed about the resumption of the Federal Reserve's rate-cutting cycle may depend on whether you are primarily a borrower or a saver. Regardless of where you fall on that spectrum, if you're an investor, now is a good time to review your portfolio and make some tweaks to accommodate — and capitalize — on a lower-rate regime.

The quarter-point rate cut from the Fed in September was the first since December 2024. The central bank followed this up with another one in October, and while it's too soon to call the December meeting, more rate cuts are expected in 2026.

Traders were recently betting that by next April, the federal funds rate (the interest rate that banks charge each other for overnight loans) would sink to a target rate of 3.25% to 3.5%, according to CME Group's FedWatch tool. That's a full percentage point lower than the Fed's benchmark rate in early September — two points lower than when the current monetary easing cycle began in September 2024.

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The good news for investors is that lower interest rates are largely positive for stocks — even in the second year of a rate-cutting cycle. Dating back to 1990, the S&P 500 Index has gained an average 11% in price in year two of Fed rate cuts, according to Sam Stovall, a market historian and chief investment strategist at research firm CFRA.

Zeroing in on how the market performs following a pause of several months during a rate-cutting cycle, Ryan Detrick, chief market strategist at wealth management firm Carson Group, found that since 1970, the S&P 500 has been higher nearly 91% of the time in the year following the resumption of rate cuts, returning an average 12.9%.

Of course, a lot depends on the health of the economy and whether rate cuts are occurring when a recession is imminent or underway or when the economy remains relatively healthy. Looking at the 45 rate-cutting campaigns going back to 1954, market strategists at Glenmede, another wealth management firm, found that the average S&P 500 gain over the course of the cycle was 13%; with no recession the average gain was 24.2%, and with a recession it was just 6.6%.

"We look at the economy as still on fairly firm footing," says Detrick. Although there are signs of labor-market slowing, there is also evidence of stronger-than-expected retail sales, he notes. "We have an okay economy being led by very strong corporate earnings growth. A Fed rate cut is the cherry on top, and they are likely to cut well into 2026. That's bullish for equities," he says.

Strong stock sectors for Fed rate cuts

Historically, the sectors that have performed best in the second year of rate cuts include real estate, financials, tech, health care and consumer staples, according to CFRA. That might not be the case this time around: Although Stovall currently recommends investors overweight stocks in the financial and tech sectors (as well as communications services), he has an Underweight rating on health care stocks, and he sees real estate and staples shares merely keeping pace with the market.

It's simply too early to shift into sectors traditionally considered more defensive, says Detrick. He still likes large-cap stocks in the financial, tech and industrial sectors, which have been leaders in the current bull market. "We're sticking with the ones who brought us to the dance," he says.

Nonetheless, it's a good time now, especially if you're nervous about the market's highfliers, to make sure you have some exposure to midsize- and small-company stocks, he adds, as well as international fare.

Lower rates may be the catalyst long-suffering small-cap stocks have needed. Indeed, on the heels of the September rate cut, the Russell 2000 Index, a popular small-cap benchmark, hit its first new high since November 2021 — an interval when the S&P 500 set 89 new highs, according to Stovall.

As interest rates drop, "small-cap companies are likely to benefit disproportionately," note the strategists from Glenmede. That's because more than half of small-cap debt is issued at floating rates. "As interest expenses fall," they say, it "should provide a meaningful tailwind to earnings."

Moreover, small firms should see a more sizable benefit from corporate tax relief, while also being less exposed to the impact of tariffs than large companies, according to Glenmede. And despite the recent rally, valuations remain compelling compared with their blue-chip cousins. "Small- and mid-cap stocks could have a very long runway — well into 2026, we think," says Detrick.

A good way to add more exposure to mid- and small-cap stocks is with the iShares Core S&P Mid-Cap ETF (IJH) and the iShares Core S&P Small-Cap ETF (IJR). Both exchange-traded funds are members of the Kiplinger ETF 20, the list of our favorite ETFs. (Prices, returns and other data are as of September 30.)

Step away from cash

You've no doubt noticed that your cash is earning less. But further deterioration in the economy — continued weakness in the job market, say — could send cash yields to the basement. "The imperative to put cash to work is increasing," say strategists in the chief investment office at UBS Financial Services.

For short-term spending needs, stick with the modest yields on certificates of deposit and money market funds, they advise. For expenses that are one to three years away, consider a bond ladder, with IOUs of staggered maturities.

Cash earmarked for needs up to five years out can be invested in intermediate-term government or investment-grade corporate bonds, according to UBS. Baird Aggregate Bond (BAGSX), a longtime member of the Kiplinger 25, the list of our favorite actively managed no-load mutual funds, yields 3.9% and has ranked in the top half of similar funds in seven of the past 10 years.

Or, recommends UBS, consider a multi-sector bond fund, whose managers can pick and choose among a wide array of fixed-income assets.

One to explore is the Pimco Multisector Bond Active ETF (PYLD). The ETF, with a yield of 5.1% and a total return of 7.0% over the past 12 months, had a hefty stake in securitized assets (think pooled mortgage loans and the like) at last report.

Finally, investors looking to replace regular income from cash, and who can tolerate the higher risk of stocks, can seek out dividend payers, such as those found in the Kiplinger Dividend 15, our favorite dividend-paying stocks.

Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.

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