By Stephon Jackson

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Rate cuts provide opportunities for U.S. small-caps and financials

Valuations remain stretched, but the market is broadening.

November 2024, On the Horizon -

U.S. equity returns were dominated by three themes in 2024: one, the rise of artificial intelligence (AI) and its derivatives; two, the strong performance of rate‑sensitive cyclical stocks in anticipation of Fed cuts; and three, soaring valuations of perceived “safe bets” despite unchanged earnings growth. In 2025, all three of these themes could unwind.

The growth rate of AI infrastructure is likely to slow due to increased competition. Cyclical stocks’ valuations are currently high after strong performance this year, although their risk/reward profile is more mixed for 2025. Many of the stocks are now at or near all‑time high valuations, with low expected growth rates.

Valuations are high across most sectors

Stretched valuations suggest that U.S. stocks will underperform bonds in the medium term (Figure 1). However, a combination of improving earnings and lower rates could result in a soft landing. We believe the Fed will continue to be data‑dependent when determining the speed and extent of the rate‑cutting cycle.

U.S. equity valuations are close to historic highs in many sectors

(Fig. 4) Returns may underperform bonds in the medium term

Past performance is not a reliable indicator of future performance.
As of October 31, 2024.
Source: Standard & Poor’s, via FactSet (see Additional Disclosures). Analysis by T. Rowe Price.
Time period range to determine the current relative valuation percentile as of October 31, 2024 is January 31, 1990 through October 31, 2024. Valuations are calculated monthly.

That said, we see a broadening opportunity set in U.S. equity markets, spanning several sectors. Small‑caps, which are trading at a historic discount to large‑caps, should benefit from further rate cuts and any signs of an improving economy. In addition, the current position of the energy cost curve indicates that we could be in for a multiyear regime change of capex and investment spend in energy, which would also benefit small‑cap stocks.

From a sector perspective, financials looks interesting. After Fed rate increases led to such poor performance for banks and real estate investment trusts in 2024, the market is anticipating better performance for this rate‑sensitive group should rate cuts continue into 2025. Energy has also underperformed significantly over the past year, but we see reasonable upside potential in several subsectors. Natural gas is attractive and likely to outperform due to limiting supply from rig count restrictions and pipeline constraints, and there is a longer‑term case for carbon‑based fuels owing to slower technological productivity gains and a delay in peak demand until after 2035.

Broader opportunities signal a stock pickers’ market

We see company‑specific opportunities in industrials given the normalization of markets following the post‑COVID volatility. Most of these are in aerospace, electrical contractors, agriculture, municipal spending, and consumer‑related building products. In health care, the life sciences sector appears likely to benefit from a reacceleration of growth in biopharma production and as early‑stage research picks back up after some major patent expirations among large pharmaceutical firms.

Elsewhere, there are plenty of software firms that were not immediate beneficiaries of AI that have strong earnings growth prospects and are attractively valued. Although utilities have traded higher recently, the sector should benefit from rising demand due to AI, and is therefore likely to deliver faster earnings growth.

Overall, we anticipate a continued expansion of investible opportunities, characterized by historically attractive valuations in certain sectors, the normalization of fundamental trends post‑COVID, and improvement in growth aided by lower interest rates and fiscal support.

Key takeaway
The key trends that dominated U.S. equities in 2024 may fade in 2025, but this will likely expand the opportunity set.

Stephon Jackson Head of T. Rowe Price Investment Management

Steph Jackson is the head of T. Rowe Price Investment Management. He is a member of the Management Committee and a member of the Black Leadership Council, and is the Executive Sponsor of Moonshot, a T. Rowe Price Foundation sponsored program supporting for-profit and non-profit entrepreneurs of color. He is the chair of the T. Rowe Price Investment Management (TRPIM) Investment Steering Committee, a member of the Investment Management Committee, TRPIM ESG and Product Strategy Committees. Steph also is the president of T. Rowe Price Investment Management, Inc.

Oct 2024 • From the Field

The Fed’s big cut may favor high yield bonds

By Timothy C. Murray

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