08 Oct 2024
Many of us have felt the pressure of prevailing high interest rates over the last few years but it looks like there is light at the end of the tunnel so it’s time to consider whether the message has changed from central banks and what the expectations and implications of the new lower rate environment will be.
Since the 2008 financial crisis, interest rates have been historically low in a bid to encourage spending and stimulate the economy. The impact of the pandemic on economic activity meant that interest rates were pushed even lower reaching a record low of 0.10% in March of 2020. Stimulus from central banks boosted growth and activity began to pick up. When Russia invaded Ukraine, energy and food prices began to rise and we found ourselves at a point where economic activity was buoyant and inflation became a monster that needed taming.
Last year there was talk that interest rates would be cut at a rapid rate but growth prevailed and inflation wasn’t as subdued as people had expected. Signs that their economies were sufficiently slowing led to Switzerland, Canada and the European Central Bank reducing interest rates. Inflationary pressures were decreasing, and the spotlight was on the US as the major world economy and when their rates would begin to fall. With inflation having returned to near target levels and growth having slowed, the Fed have now cut interest rates by 50 basis points. There are still inflationary pressures – it’s never a perfect story – but with employment showing signs of tailing off, the mandate focus switched to the more prevailing requirement: maintaining employment to ensure that the economy didn’t take a nosedive.
The Bank of England doesn’t have an employment mandate, but employment is of course seen as a key contributor to a thriving economy. The question now is what can we expect going forward? The trajectory is that interest rates will continue to fall but at what pace? The escalation of tensions in the middle east is a clear threat to inflation and could have an impact on how fast interest rates fall globally. There is no expectation that rates will reduce to the ultra-low levels experienced in response to the pandemic, but central banks are trying to bring us back to a pre-GFC environment. Banks have shown that they are willing to act but unless there is a need to reduce rates fast due to economies showing signs of declining, cuts are likely to be more gradual across the world.
Data on economic activity can be highly influential when adjusting portfolio positioning. How can we protect our investments in the current economic environment and where are the openings? Fixed income investments are one to watch as they are producing relatively high and attractive rates of income. The market looks forward and prices have risen to reflect the fact that rates will fall, but you can still buy fixed income investments which pay an appealing recurring income leading to capital stability and capital gains.
There’s a strong argument for fixed income having a place in portfolios but what about other potential strategies? If we believe that economic activity will continue at a stable rate, falling interest rates should mean that equities will benefit. A focus on how you invest in equities could come into play, highlighting value and capital style strategies. A relatively defensive approach focusing on the level of income and return of capital to shareholders through share buy backs which support values can allow for steady gains in a falling interest rate environment with steady growth.
When it comes to expenditure on AI, have the baked in expectations of growth in some of the mega caps gone too far and what will the actual return on investment be? Companies don’t want to get left behind so are maintaining their position for the longer term, but the earnings of these companies could potentially be at risk. High levels of growth are priced in and even if growth prevails, failure to match expectations can send prices tumbling.
What about other opportunities in the market? Areas that may have been overlooked, are already priced for a slow down or have already experienced some recessionary pressures and are at bargain basement prices are worth seeking out. If we accept the theory that central banks can maintain growth at subdued but positive levels and slowly bring interest rates down, a company that pays a high dividend or is buying back shares, returning capital to shareholders, and is priced at a low multiple, may be an appealing proposition.
Markets may become less thematic when it comes to AI technology and more focused on value, growth and multiples to ensure value for money so growth or value investing at reasonable prices could be a primary strategy. This speaks to small, mid cap and many of the large cap companies in the US that fall outside of the mega cap companies that have been driving the market. We’ve already seen volatility in some of the mega cap stocks such as Nvidia with slight undershooting of expectations resulting in tumbling prices, so there’s a readiness for investors to shift their approach. The weighting of active versus passive funds which might be able to protect the value of the investments under management is another element worth consideration in this falling rate environment. Apply the data, select your stocks carefully, seek the openings and you’ll be on the road to optimal portfolio positioning as interest rates fall.
Tim Sedgwick, Investment Research Manager
Katie Sykes, Client Engagement & Marketing Manager
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