Monthly portfolio brief

Interest rates: Risk or opportunity for your portfolio?

What you need to know

• Interest rates rose toward year-end, driven by resilient economic growth and a more cautious Federal Reserve, pressuring portfolios.
• Market leadership narrowed once again as growth-style investments reclaimed the lead from interest rate-sensitive and cyclical segments of the market.
• With inflation likely contained and economic growth moderating, we believe interest rates are positioned toward the high end of their general range for 2025.
• Consider opportunities within U.S. stocks, where we believe U.S. large- and mid-cap stocks appear attractive, particularly given the beneficial economic backdrop.
• The recent interest rate spike has increased bonds’ future return potential, supporting our recommendation to overweight longer-duration bond investments.

Portfolio tip

Help prepare your portfolio for a variety of interest rate environments by diversifying investments across regions, styles, sectors, credit quality and bond maturities.

Where have we been?

Interest rates rose on resilient economic growth and a cautious Federal Reserve, pressuring portfolios. 2024 was another strong year for the U.S. economy. In December, the Fed raised its full-year economic growth estimate to 2.5% from 2%. The U.S. economy has demonstrated this resilience despite elevated inflation. While inflation has made meaningful progress lower, it remains above the Fed’s long-term 2% target.

Given these recent data points, among others, the Fed indicated it will likely continue interest rate cuts in 2025, but perhaps not as fast or as far as previously expected. As a result, longer-term interest rates generally rose during the last three months of 2024, even while multiple central banks cut their short-term monetary policy rates. Higher rates dimmed the growth outlook, weakening markets and well-diversified portfolios in December.

Markets narrowed, with growth-style investments reclaiming the lead as interest rate-sensitive and cyclical markets struggled. Some markets tend to respond more than others to changes in interest rates or economic growth expectations. Given the greater likelihood for interest rates to stay higher for longer, possibly weighing on economic growth, interest rate-sensitive and economically sensitive segments of the market underperformed in December.

U.S. stock and bond markets were hit particularly hard. The U.S. small- and mid-cap stock asset classes, which are more cyclical than U.S. large-cap stocks, fell the most last month. Similarly, the industrials, materials, real estate, utilities and energy sectors within U.S. large cap dropped about 8%–11%.

In another display of the narrow leadership that has defined markets in recent years, tech- and growth-oriented stocks finished the month higher. Their outperformance helped prop up U.S. large-cap stocks and emerging-market equity, particularly given how they make up a higher portion of these two asset classes.

Within fixed income, U.S. investment-grade bonds trailed the most, given the Fed’s more cautious stance. The stability of cash and cash-like investments, on the other hand, helped support well-diversified portfolios in December.

2024 ended with all asset classes in positive territory despite year-end volatility, highlighting the benefits of a longer-term focus. Inflation trended lower over the course of the year. This allowed major central banks to ease monetary policies, providing a tailwind across markets. While all 11 of our recommended asset classes are higher as a result, U.S. equity markets hold the lead, boosted by relative economic momentum and growth prospects from tech innovations.

Emerging-market equity followed, propelled by the potential for economic stimulus from Chinese policymakers. But all three international equity asset classes (small-, mid- and large-cap) were held back in 2024 by the strengthening dollar, particularly in the last quarter of the year.

With gains greater than 5%, returns within higher-yielding segments of the bond market were also impressive. But following the fourth-quarter interest rate spike, higher-grade U.S. bonds were the year’s laggards, ending 2024 only slightly positive.

What do we recommend going forward?

Interest rates will continue to fluctuate, which creates risks and opportunities for portfolios. The key is to know how to manage the risks and incorporate timely opportunities in your portfolio.

Here are three steps we recommend:

1. Prepare your portfolio for a variety of interest rate environments. Diversification can help smooth a portfolio’s overall volatility, including volatility related to potential interest rate fluctuations. For example, interest rates move differently across regions and can even move in opposite directions. Therefore, we recommend allocations across domestic and international markets, including exposure to developed and emerging economies. 

Additionally, different asset classes, styles, sectors and bond maturities carry different levels of interest rate sensitivity, highlighting another benefit of diversification. Lower-quality bonds generally provide higher income potential, which can help offset a drop in bond prices caused by a rise in rates.

To help build an all-weather portfolio as interest rates shift, consider using the following strategic asset allocation guidance to align your portfolio’s long-term diversification with your risk and return objectives.
 

2. Overweight U.S. large- and mid-cap stocks, given the potential for increasingly supportive economic policies amid a solid backdrop. Policy shifts are likely to dominate headlines in the months ahead, particularly given the transition to a new U.S. administration, which may drive periods of volatility and impact interest rates. While the exact timing and size of additional monetary and fiscal policy measures remain uncertain, we believe they’ll become increasingly supportive of economic growth in 2025. The U.S. economy is standing on a solid foundation as we enter 2025, a year when the Fed expects growth to remain slightly above 2%. 

Despite the Fed more more slowly reducing short-term rates to levels that neither stimulate nor constrain growth, we continue to believe the direction for rates is generally lower in 2025. This would further solidify a backdrop for equities to outperform bonds, in our view. 

The incoming U.S. administration has indicated support for pro-growth policies such as deregulation and extended tax relief, providing a tailwind for U.S. equities. Tariff and trade policy uncertainty, on the other hand, weakens the outlook for developed international equities, in our view. 

We believe more economically sensitive asset classes and sectors, particularly those with relatively attractive valuations, are likely to benefit, helping to continue broadening markets. We recommend shifting allocations from U.S. investment-grade bonds and international developed-market stocks toward U.S. large- and mid-cap stocks.
 

3. Lean into interest rate risk by overweighting emerging-market debt and higher-quality intermediate-term bonds. With inflation likely contained, economic growth moderating and central banks continuing to cut rates, we believe interest rates are near the high end of their likely range for 2025, even if they overshoot at times. While the recent interest rate spike weighed on bond returns toward the end of 2024, higher interest rates enhance bonds’ future return potential, creating another opportunity for investors to lock in higher rates for longer.

We recommend leaning into interest rate risk in this environment by reallocating from short- to intermediate-term U.S. investment-grade bonds. Even if longer-term interest rates remain rangebound, which could limit the return from appreciating bond prices, their income potential has become increasingly attractive in recent months. Additionally, the central bank rate-cutting cycle highlights the reinvestment risk of cash-like and short-term bond investments.

Last, we recommend overweighting emerging-market debt, partially because of its higher interest rate sensitivity compared to that of U.S. high-yield bonds. The latter have also outperformed recently, highlighting the catch-up potential of emerging-market debt, particularly in this environment.

We’re here for you

Interest rate fluctuations can’t be controlled, but the risks within a portfolio can be. Our investment professionals are constantly monitoring the market environment, evaluating the global outlook and identifying risks and opportunities. 

Consider discussing our 2025 outlook with your financial advisor. This report provides more details about our portfolio guidance designed to help you navigate risks and opportunities in the current environment.

If you don’t have a financial advisor and would like help identifying opportunities for your portfolio, we invite you to meet with an Edward Jones financial advisor.

Strategic portfolio guidance

Defining your strategic investment allocations helps to keep your portfolio aligned with your risk and return objectives, and we recommend taking a diversified approach. Our long-term strategic asset allocation guidance represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class will depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.

Diversification does not ensure a profit or protect against loss in a declining market.

Opportunistic portfolio guidance

Our opportunistic portfolio guidance represents our timely investment advice based on current market conditions and a shorter-term outlook. We believe incorporating this guidance into a well-diversified portfolio may enhance your potential for greater returns without taking on unintentional risks, helping keep your portfolio aligned with your risk and return objectives. We recommend first considering our opportunistic asset allocation guidance to capture opportunities across asset classes. We then recommend considering opportunistic equity style, U.S. equity sector and U.S. investment-grade bond guidance for more supplemental portfolio positioning, if appropriate.