Fed Chair Jerome Powell has telegraphed that a lower interest rate cut is “on the table” for September. The CME FedWatch tool is now predicting a 73.5% probability of a 25 basis point rate cut at its September 18 meeting, with a lower likelihood (26.5%) of a 50 basis point cut. This would mark the first rate cut since the Fed began hiking interest rates in 2022 to curb inflation.
Besides the implications for the bond market, the yield curve, and inflation assets, lower interest rates stand to benefit many investment themes that are interest rate sensitive. Economic segments that are capital-intensive or on a rapid growth trajectory stand to benefit the most. This is especially the case in cyclical stock sectors such as consumer discretionary, technology, real estate, and financials.
Let’s explore some themes likely to benefit in a declining interest rate environment amid lower borrowing costs.
Small-Cap Stocks
According to a study comparing the Russell 2000 Small Cap Index to the S&P 500 quarterly since 1970, small cap stocks outperformed large caps 76% of the time in the 12 months after earnings rose and interest rates fell. Small caps typically benefit the most from rate cuts, assuming the economy avoids recession. This time, the effect could be particularly pronounced given that the performance disparity between large and small cap stocks is so wide (as seen in the chart below). That is, except for a brief period of small-cap outperformance in 2021.
Junior Miners
One theme that stands to benefit from both small cap exposure and high capital intensity are mining stocks. This particularly applies to select junior miners. This is especially true for mining exposure tied to technology and clean energy applications. One example is the Amplify Junior Silver Miners ETF (SILJ), which is up 9.5% YTD and has $877 million in assets. Silver as a commodity has had a nice run this year as an electrically conductive metal with industrial applications. This would include solar panels and medical devices. It is also up more than gold.
Another intriguing junior mining play is the Sprott Junior Copper Miners ETF (COPJ), the only pure-play ETF targeting small copper miners. Junior copper miners stand to benefit from declining interest rates. The increased copper demand associated with clean energy infrastructure, energy storage systems, and electric vehicles. Sprott also has another interesting junior mining ETF, the Sprott Junior Uranium Miners ETF (URNJ), which is focused on small uranium miners. Increasingly, uranium and nuclear power are being considered as a “cleaner” means of meeting net-zero energy goals and achieving energy security.
Junior gold mining ETFs like the VanEck Junior Miners ETF (GDXJ) and the Sprott Junior Gold Miners ETF (SGDJ) also have small cap mining exposure. Still, gold is also driven by many complicating macro-considerations, so these funds have been left off the list for now.
Clean Energy
Clean energy projects are very capital intensive and have suffered in a higher interest rate environment. These ETFs will likely benefit from lower interest rates, especially with regulatory support.
Which clean energy ETFs are most leveraged to small cap and interest rate sensitive exposure? Two ETFs with a high (above 80) correlation to small-caps are the Invesco Wilderhill Clean Energy ETF (PBW) and the SPDR S&P Kensho Clean Power ETF (CNRG). Both these funds are poor performers YTD but are poised for a rebound as rates come down.
Small Banks
Small-cap financials are another thematic segment likely to rally as rates decline. Small-cap banks, in particular, were rocked by the March 9, 2023, mass exodus from their stocks. This was triggered by the failures of Silicon Valley Bank and Signature Bank. However, since then, they have all but recovered to their previous levels.
Regional Bank ETFs such as the iShares US Regional Banks ETF (IAT), the SPDR Regional Banking ETF (KRE), and the Invesco KBW Regional Banking ETF (KBWR) all stand to benefit as rate pressures ease.
Biotechnology
Biotech is also a capital-intensive market theme that is helped by lower interest rates. Stocks in the category struggled for quite some time after reaching new highs during the COVID period.
As rate headwinds abate, biotech seems positioned for a rebound, especially given the many new promising technologies in the pipeline.
ETFs that stand to benefit from a rebound in biotech include the ALPS Medical Breakthroughs ETF (SBIO), the iShares Biotechnology ETF (IBB), the First Trust NYSE Arca Biotechnology Fund (FBT), and the VanEck Biotech ETF (BBH).
Credit-Linked Consumer
Many credit-linked consumer themes, such as automobile sales, real estate, and retail, will also benefit from lower interest rates. Lower interest rates will make car purchases more affordable. This is especially the case in the electric vehicle category, which is still more expensive than its gas-powered peers.
Automobile ETF plays include the First Trust S-Network Future Vehicles & Technology ETF (CARZ) and the Amplify Lithium & Battery Technology ETF (BATT). BATT also has some mining exposure as a bonus.
Besides automobiles, lower rates should also help durable goods retailers, such as those selling furniture and household appliances, as well as improvements. Those categories could also benefit from a resurgence in housing mobility.
Housing
Homebuilders and housing have been a surprisingly strong theme even amid a 22-year high in mortgage rates. Declining rates could eliminate the bottleneck of high rates, as sky-high mortgage rates have frozen residential mobility. Existing homeowners are unwilling to give up their low rates and are essentially trapped.
Some ETFs tied to this theme are homebuilder ETFs like the SPDR S&P Homebuilders ETF (XHB), the iShares U.S. Home Construction ETF (ITB), and the Hoya Capital Housing ETF (HOMZ). Homebuilders also fall into the smaller cap category of exposure.
Another interesting quasi-real estate play is the First Trust Alerian Disruptive Real Estate ETF (DTRE). It includes exposure to communication tower REITs and the next-generation telecommunications buildout. The ETF is also very capital-intensive and is helped by lower rates.
Finally, Invesco has the Invesco S&P 500 Equal Weight Consumer Discretionary ETF (RSPD), which provides broad exposure to this theme, and its equal-weighting methodology skews the fund toward smaller and mid-cap names. Now, the ETF is only up a modest 3.7% YTD and is not seeing inflows. However, RSPD may be an example of where the puck is going in a lower-rate environment.
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VettaFi LLC (“VettaFi”) is the index provider for DTRE, SFIO, CARZ, and BATT, for which it receives an index licensing fee. However, DTRE, SFIO, CARZ, and BATT are not issued, sponsored, endorsed, or sold by VettaFi. VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of DTRE, SFIO, CARZ, and BATT.