Where Top Stock Fund Managers Are Looking Next After the Fed Rate Cut

The Federal Reserve’s aggressive half-percentage-point interest-rate cut helped fuel a new push in the stock market to record highs, but some top-performing stock managers say the next leg of the rally is likely to look quite different from the tech-driven push of the last two years.

The “Magnificent Seven,” a group of mega-cap stocks concentrated in the tech sector, have dominated US stock market returns. The firms—Nvidia NVDA, Tesla TSLA, Microsoft MSFT, Alphabet GOOGL, Meta Platforms META, Apple AAPL, and Amazon.com AMZN—now make up more than a fourth of the Morningstar US Market Index.

Now, with interest rates falling, the door is open for other segments of the market to shine as consumers are better able to make big purchases and smaller firms are less hampered by debt.

“The Magnificent Seven has been the dominant large-growth franchise for almost two years. This [rate cut] opens up the door for a lot more stock-specific dispersion,” says Jodi Love, lead portfolio manager of four exchange-traded funds at T. Rowe Price. “The Mag Seven are still going to put up impressive growth numbers, but the rate of growth is decelerating, and the rate of growth of names outside the Mag Seven is going to accelerate.”

Fed Provides Some Economic Insurance With Big Rate Cut

The Fed Wednesday announced a half-percentage-point cut in the federal-funds rate, taking its target rate down to 4.75%-5.0%. Going into the Fed meeting, there was disagreement among investors whether the Fed would cut rates by 0.25 or 0.50 percentage points.

“We thought it was a close call, but [a half percentage point] was the right move,” says Tony DeSpirito, global chief investment officer of fundamental equities at BlackRock. “The 3.2% core [Consumer Price Index] print we saw in August was the smallest 12-month increase since the spring of 2021 … We have seen unemployment rise off its lows, moving up 0.5% from the start of 2024,” he added.

Felise Agranoff, a portfolio manager within the US equity group at JPMorgan, was surprised by the bigger cut. “But what it shows me is that the Fed is going to support the economy, and they’re not going to let unemployment tick up very much.”

This 0.5% uptick in the unemployment rate may have been a warning light for the Fed prompted by an economic theory known as the Sahm rule. The rule states that if the unemployment rate rises by more than 0.5% over the course of a year, it signals a recession. This may have pushed the Fed to cut more aggressively than it might otherwise have.

“In my view, the big move out of the gates takes out some insurance on a soft landing scenario,” says T. Rowe’s Love.

Consumer Discretionary: Housing and Car Sales Set to Come Back

The interest rates of the past two years hit sectors where consumers finance their purchases through borrowing. Consumer discretionary sectors such as autos and housing are particularly prominent examples.

“Interest rates went up so much so quickly,” says JPMorgan’s Agranoff. “It was pretty unprecedented relative to history, and I think that it just really did cause a choking off in demand, particularly in some of the bigger ticket items that are more rate sensitive.”

“Everyone remembers the huge shortage of cars during covid, and that was pushing pricing on new cars to record levels,” Agranoff adds. “So you would have thought, when supply ramped back up, that you would have seen a demand response … given where rates were and that pricing had risen so substantially for cars, you didn’t actually see much of a demand response. And so that remains kind of pent-up demand.”

Even more so than cars, homebuying goes hand-in-hand with financing for consumers, and the shock of higher rates causes significant disruption to that market.

“With mortgage rates having moved so quickly, everyone is just kind of stuck in place, because if you had a 3% mortgage, the idea of moving and doubling your mortgage rate is not very attractive,” says Agranoff. He notes that, going forward, “They don’t have to go back to 3%, but they have to go back to a more reasonable level. And then what we think you’ll see is we’ll start to see more existing home turnover again.”

Homebuilder stocks spent 2022 and most of 2023 languishing, but as hopes for a rate cut rose at the end of 2023 on softening inflation, this caused the sector to begin rising throughout 2024.

As for specific firm names, Agranoff mentions Pool POOL, which does construction and repair, as well as discount retailer TJX TJX, which sells home goods.

DeSpirito also mentions that homebuilders will benefit from the decline in mortgage rates, which he says are down to their lowest level in two years.

Software to Shine After Hardware’s Rise

While tech stocks have been rising, much of that interest has been focused on semiconductor manufacturers such as Nvidia. The Morningstar US Semiconductors Index has absolutely trounced the Morningstar US Software Capped Index since the beginning of 2023; however, that may be changing.

“We’ve been leaning more into software over semis,” says T. Rowe’s Love, with multiple other managers agreeing that it was software’s time to shine.

“There’s a lot of chatter around AI but a lot of spending around the cloud. So we looked at a name like Oracle ORCL, which has had some very strong results recently. It’s our largest holding in the tech space,” says Matt Quinlan, portfolio manager for two income-focused stock funds for Franklin Templeton.

“If you look at software valuations … we’re back down to long-term averages,” says Agranoff, who says this compares with 2020 and 2021 when valuations were close to 3 times what they are now. “We haven’t really seen them start to come back up, because most of leadership has been led by AI and semiconductors and not software,” she adds.

Mid-Caps and Dividends to Return

Sectors aren’t the only areas where lower rates may open opportunities. Different strategies may also have their time to shine, with managers highlighting mid-cap and dividend-paying stocks in particular.

Mid-cap stocks have trailed large-cap ones for close to two years, with the Morningstar US Mid Cap Index up 30.5% since the beginning of 2023 compared with 56.6% for the Morningstar US Large Cap Index. Multiple factors may allow them to shine moving forward.

“We see mid-caps benefiting from the lower rate environment, as these companies tend to have more floating-rate debt than their large-cap counterparts,” says BlackRock’s DeSpirito. Floating-rate debt, like an adjustable-rate mortgage, rises and falls along with broader interest rates, so falling rates are likely to disproportionately help mid-caps.

“I do believe the small and middle-cap will be the biggest beneficiary of falling rates,” says T. Rowe’s Love, who points to consensus earnings growth estimates for the large-cap S&P 500 compared with the small-cap S&P 600. “The [consensus earnings growth] for the S&P 500 for 2024 is 9%, and for 2025 it’s 15%. If you look at the S&P 600, consensus is 4% this year and over 20% for 2025,” says Love.

“I tend to be more bullish on mid-caps than small caps,” says JPMorgan’s Agranoff. “I would say the quality of the assets, at least with growth stocks, isn’t as high,” she adds. She says that a major reason for this is when companies are choosing to go public, either going public when they’re too small and unable to reach profitability or going public much later in their lifecycle.

“A lot of the best assets are waiting till they get to mid-cap, some even large-cap, before going public,” says Agranoff.

The other strategy likely to gain traction is dividend investing, because falling rates will lower the yield investors can get on cash and bonds.

“We have seen a significant pickup in interest for equity strategies that deliver income as the Fed rate-cutting cycle has crystallized. Our Equity Dividend strategy MADVX and High Equity Income BMCIX have received more attention as clients are recognizing the 5%+ they were receiving on cash during the last several years is going away,” says DeSpirito.

Quinlan, whose funds focus on income, agrees: “[Our funds’] yield stands out as less compelling when you can get 5% in cash.”