These 2 ETFs Could Outperform as Jerome Powell Lowers Rates

The Federal Reserve recently cut its benchmark federal funds rate by 25 basis points to 4%-4.25%, with the FOMC's dot plot indicating expectations for two more cuts in 2025 and one in 2026, signaling a continued easing cycle. This falling-rate environment is projected to significantly benefit real estate and small-cap stocks, as lower borrowing costs stimulate investment in real estate and improve the financial health and attractiveness of small-cap companies with floating-rate debt.

Analysis

The Federal Reserve has initiated a monetary easing cycle with a 25 basis point 'risk management cut' to the federal funds rate, bringing it to a range of 4.00% to 4.25%. Forward guidance from the FOMC's dot plot indicates a measured but clear path forward, projecting two additional cuts in 2025 and one in 2026, with the rate settling around 3.4%. While this terminal rate is noted as higher than market expectations, the dovish trajectory is positioned to benefit specific asset classes. The real estate sector, represented by the Real Estate Select Sector SPDR Fund (XLRE), is expected to gain from lower borrowing costs and compressed capitalization rates, with the fund's 3.28% yield offering attractive passive income. Similarly, small-cap value stocks, as tracked by the Vanguard Small Cap Value ETF (VBR), are poised to benefit as lower rates reduce the burden of floating-rate debt and increase investor risk appetite. VBR's 86% five-year return has lagged the S&P 500's 100%+ gain, suggesting potential for a catch-up trade, further supported by its significant exposure to rate-sensitive financials (21%) and consumer discretionary (14.6%) sectors. However, potential recessionary risks for smaller firms and acknowledged 'complexities' in the real estate market remain as key moderating factors.

Key Decisions for Investors

• Given the Federal Reserve's dovish pivot with a projected easing cycle through 2026, investors should consider a tactical overweight to rate-sensitive sectors, specifically real estate and small-cap value stocks.
• Evaluate the Real Estate Select Sector SPDR Fund (XLRE) for its potential to provide both capital appreciation and a 3.28% dividend yield in a declining rate environment.
• Consider the Vanguard Small Cap Value ETF (VBR) as a potential value and catch-up play, but remain cognizant of the inherent risks to smaller companies should the economy tip into a recession.
• Monitor macroeconomic indicators closely, as the higher-than-expected terminal rate of 3.4% could temper asset price appreciation if economic growth falters more than anticipated.