While experts disagree on the timing, the overwhelming consensus is that the Federal Reserve's next interest rate move will be a cut. Even the latest projections from the policymakers at the Federal Reserve call for interest rates to be significantly lower in a year or two than they are today.
If we enter a rate-cutting cycle, it will likely be a positive catalyst for stocks in general. But there are a few areas of the financial markets that could be especially big winners.
Real estate could be a big winner as rates fall
Real estate investment trusts, or REITs, tend to be highly rate-sensitive stocks. Not only do rising interest rates increase the cost of borrowing money, which is a big part of the real estate industry, but the yields of income-focused investments like REITs tend to rise alongside the yields of risk-free instruments like Treasury bonds. Since yield and price have an inverse relationship, this puts pressure on REITs.
In fact, since the start of 2022 when the Fed's rate-hike cycle began, the Vanguard Real Estate ETF (VNQ 0.55%) has fallen by about 30%.
However, there's one important thing to keep in mind. The underlying businesses owned by this exchange-traded fund are generally doing fine, especially top holdings like Prologis, Equinix, and American Tower. As rates start to fall, the Vanguard Real Estate ETF could certainly enjoy years of market-beating total returns, but this is an excellent ETF to consider for your portfolio regardless of what interest rates do.
Small caps and value stocks could benefit from lower rates
Small-cap stocks went into 2024 trading for the lowest valuation relative to their large-cap counterparts since the late 1990s, and the gap has widened so far this year. Value stocks have also underperformed growth stocks in recent years. The Vanguard Small-Cap Value ETF (VBR 0.74%) could be a big winner if these valuation gaps start to close, and Federal Reserve rate cuts could be a big catalyst to make this happen.
There are a few reasons why falling interest rates could help this ETF outperform. For one thing, both small-cap and value stocks tend to be more debt-reliant than their large-cap and growth stock peers, and falling rates would make debt cheaper. Plus, as rates fall and risk-free investments become less appealing, more money could flow from the sidelines into investments perceived as more volatile like small-cap stocks.
The Vanguard Small-Cap Value ETF has underperformed the S&P 500 by about 18 percentage points since the start of 2023. But if rates fall, that could be about to change.
Two solid ETFs regardless of when rates start to fall
As a final point, it's important to mention that nobody knows for sure when interest rates will start to fall. The first rate cut could come as soon as June or July, but if the economic data isn't showing strong progress with inflation, the Fed could decide to hold rates steady until 2025.
However, there are two key points to keep in mind. First, regardless of the timing, both of these should benefit when rates eventually start to fall. And second, both of these are solid ETFs to buy and hold for the long term. I own these two stock-based ETFs in my own portfolio and plan to keep them for decades. Now just happens to be an interesting point in the economic cycle, and it could be a great time to buy.
