As the Fed eases up, it could pay to own a mix of defensive and cyclical stocks, and non-U.S. bonds. By Ian Salisbury

The Federal Reserve just cut interest rates again. But investors won't know what it ultimately means for stocks and bonds until they see how many more cuts are coming down the pike.

On Wednesday, Fed officials lowered the benchmark Federal Funds rate by a quarter-point, the central bank's first rate cut since December. Markets had largely priced in the news -- and perhaps their hopes for several more. The S&P 500, up 12% this year, recently topped 6600, with many strategists seeing 7000 within sight for 2026. Bonds yields have fallen this year, with the 10-year Treasury note down to 4% from 4.75% in January.

The Fed's so-called dot-plot graph hinted on Wednesday that officials expect two more quarter-point cuts in 2025 -- but there is no guarantee of additional cuts. Fortunately, there are ways to prepare your portfolio if the Fed cuts mildly or deeply later this year, reflecting either an economic slowdown or growth recovery in 2026. While valuations are steep, with the S&P 500 at 22 times earnings, there are still relative bargains to be had.

Today's economic situation is unusual. President Donald Trump's tariffs are expected to dampen growth and exert upward pressure on inflation. But the extent is debatable. The economy, meanwhile, should benefit from Republicans' tax cuts, along with productivity gains related to artificial intelligence, and investment in domestic manufacturing.

For now, the Fed is cutting as insurance against a recession. The Atlanta Fed's GDPNow model, a snapshot based partly on real-time data, forecasts third-quarter economic growth at 3.4%. The Conference Board, a nonpartisan entity, sees real GDP growth in the 1%-2% range next year.

What does it mean for stocks? A lot depends on how many total cuts the Fed makes in 2025. One clue may come from how cyclical and defensive sectors fared historically when the Fed started cutting after an extended pause, the situation we appear in today.

Going back to 1976, cyclical sectors beat defensive ones when the Fed cut two or fewer times, according to Ned Davis Research. In cycles with four or more cuts, defensive sectors outperformed over the following six months.

The divergence makes sense: The Fed typically has to cut more if the economy is weakening rapidly, prompting investors to seek safety in defensive areas like utilities, consumer staples, and healthcare. If the economy needs fewer cuts to stay aloft, the market rewards cyclicals like banks, tech, and industrials, along with small-caps.

How to Play Defense

A good place to start is healthcare. The sector is ailing, down 0.5% this year, making it the worst performer in the S&P 500. But it looks attractive as a bulwark. Valuations are low at just 17 times earnings, versus the market average of 22 times forward earnings.

Healthcare faces plenty of challenges -- including pressure on drug prices -- and higher costs for insurers. But historically, it has fared well when the Fed has cut at least four times after a pause. The sector outperformed in two of those three instances, in 1986 and 1990, Ned Davis found, with a median gain of 20% in the six months after rate cuts started.

The Health Care Select Sector SPDR exchange-traded fund offers broad exposure to the group. For a more targeted approach, consider UnitedHealth Group. The stock is down more than 31% this year, thanks to higher-than-expected costs at its Medicare Advantage business. But it may have turned a corner. In August, the stock got a vote of confidence from Warren Buffett's Berkshire Hathaway, which disclosed it recently purchased five million shares. Earlier this month, shares leapt 8% after the company said in a securities filing that its business was performing to expectations.

Eli Lilly, down 3% so far this year, may also be due for a rebound. Investors have been concerned about competition for its weight-loss blockbusters Zepbound and Mounjaro. But the selloff may be overblown. Drugs from some would-be rivals haven't tested as well as investors feared.

Consumer staples have some history as defensive winners. The sector gets its name from companies that sell necessities -- think Procter & Gamble, Coca-Cola, Philip Morris International, and CVS Health. The sector is up just 7.5% this year, but it historically gained 20% when the Fed cut at least four times after a pause, according to Ned Davis.

Two names that stand out as turnaround plays are Campbell's and Constellation Brands. Both companies look undervalued, according to Morningstar. The stocks are down 17% and 38% this year, respectively, on tariff worries. But Campbell's recently reported better-than-expected fourth-quarter earnings. Constellation, a beer and spirits maker with big brands such as Modelo and Corona, is likely to weather the headwinds, Morningstar says.

Energy typically benefits from rate cuts, but the outlook isn't great; OPEC is expected to continue hiking production, keeping a lid on oil prices into 2026.

Within energy, however, one area that looks attractive are master-limited partnerships, or MLPs. The firms operate pipelines, processing plants, and other "midstream" parts of the energy complex. They have some insulation from commodity pressure and, because they are legally required to payout 90% of earnings as income, they boast yields in the high single digits.

The Alerian MLP ETF, which tracks the sector, yields just above 8% and is up 5.1% this year including distributions. Big names in the ETF include Enterprise Products Partners and Western Midstream Partners, among others. Investors could own those MLPs individually and get a little more income, but the firms issue complex K-1 tax forms; owning them through an ETF avoids that complication.

Utilities have gone from the sleepiest sector to one of the sexiest. Electricity demand is surging because of AI and data center growth. The sector now trades at 18 times forward earnings, well above the long-term average of 15.

Hot nuclear power companies like Vistra and Constellation Energy have pushed up valuations. But even slow-and-steady regulated utilities are riding increased power demand to higher profits, says Tim Winter, co-portfolio manager of the Gabelli Utilities Fund.

Traditionally, 3% in annual profit growth was typical in utilities. Today, Wall Street forecasts call for 8% to 9% growth.

One stock Winter likes is Idacorp, a regulated utility that is well-positioned to capitalize on Idaho's dramatic population growth. The company, which forecast 4% to 6% profit growth for 2025, filed with its state regulator in May for an overall 13% rate increase.

Another pick is WEC Energy Group, a mostly regulated gas and electric utility headquartered in Wisconsin where Microsoft last year announced plans for a $3 billion data center. Wall Street analysts that follow the company forecast earnings per share growth of 6% to 7% on average over the next two years.

Sticking With Cyclicals

Assuming the economy avoids a recession, growth stocks and cyclicals are likely to maintain their leadership. Tech is the obvious choice, though valuations are steep. Industrials would also benefit, though they also have an Achilles' heel: The sector is trading at 24 times earnings, one its highest levels in 25 years.

By contrast, banks aren't especially pricey and should get a tailwind from a steepening yield curve -- a drop in short-term rates that widens the gap with long-term rates. That would be a boon to banks, lifting their net-interest margins on loans, notes Sam Stovall, chief investment strategist at CFRA Research.

While the sector is up 11% this year, Stovall still sees values in laggards like PNC Financial Services (up 7.1%) and Fifth Third Bancorp (up 8.5%). He also likes Citigroup, which has soared nearly 46%, but trades at 13 times earnings, below the industry average of 14 times.

Small companies, with less-established business models, benefit from lower rates because they tend to have heavier debt loads and borrow at floating rates. If the Fed can deliver lower rates while the economy remains strong, it could be small-caps' Goldilocks moment.

Small-caps are no longer trading at historically low valuations, according to BofA Securities strategist Jill Carey Hall. But even at today's levels -- 16 times forward earnings -- they look cheap compared with historically stretched large-caps, she adds.

Hall thinks small-caps' rally will continue for a few more weeks and could stretch into next year if manufacturing activity ticks up and the U.S. avoids another tariff crisis.

Stick with higher-quality small-caps that tend to be more resilient in a downturn. The iShares Core S&P Small Cap ETF screens for the 56% of small-cap companies that are profitable. The ETF has a 1.5% dividend yield, compared to just over 1% for the Russell 2000 or S&P 500.

Real estate stocks have languished since the Fed began raising rates in early 2022. With short-term rates finally coming down, the sector looks due for a snapback. Wall Street expects REITs to deliver earnings growth averaging 6% to 7% over the next two years. The sector's 3.3% dividend yield is highest in the S&P 500.

One potential growth area is senior housing, which benefits from the U.S. aging population; another is data centers, which stand to capitalize on the AI boom, according to Greg Kuhl, portfolio co-manager of the Janus Henderson U.S. Real Estate ETF.

"They're both supply-and-demand stories," he says. Kuhl's fund has Welltower, the largest REIT in the senior living category, as well as AI bets Equinix and Digital Realty Trust, among its top five holdings.

Threading the Bond Needle

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September 19, 2025 21:31 ET (01:31 GMT)

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