“The Bank of England has fired the starting gun on interest rate cuts, making the first reduction to rates in more than four years this month,” says AJ Bell personal finance director, Laura Suter. “We’re not expecting to see interest rates go back to the low levels seen previously any time soon, instead the expectation is for slow and small cuts to interest rates over the next year or so. But with both record high inflation and high interest rates hopefully in the rear-view mirror, what do lower interest rates mean for markets? And how could they impact investor portfolios?
“Changing interest rate environments are usually an opportunity for different asset classes, countries or types of company to flourish, while the rallies we’ve seen in other markets may draw to a close. With just one small interest rate cut under our belts we’re not expecting a full-scale pivot in markets, but investors could prepare their portfolios for different market conditions.
“One thing to factor in is that often it’s interest rate expectations that determine market direction, rather than the actual changes to rates. Because markets have been expecting interest rates to be cut for some time, a portion of the impact will have already been baked into market pricing.”
Stock markets
“Broadly, equity markets should benefit from a cut to interest rates, as it makes cash less attractive and should drive more people back into investing. While interest rates have been high savers have been able to get decent, guaranteed returns on cash, both in easy-access and fixed-term accounts, which has made investing less attractive by comparison. However, in a falling interest rate world cash rates will gradually become less attractive, tipping the balance back in favour of investing. More money being invested has the simple effect of driving up prices, thus boosting markets. But not all stocks will rise equally, and there are some companies that should benefit more.
“One way to play the trend is to buy small cap stocks, as they have been unloved for a long time and so have more potential for growth. Markets have been anticipating interest rate decreases for some time, and as a result we’ve seen small caps moving higher since last Autumn, with the FTSE UK Small Cap index rising by 24.9% since the end of October last year compared to the 14.9% return from the FTSE 100. But there could still be some life left in the trend.
“One particular beneficiary of lower interest rates could be companies that rely on consumer spending. Lower interest rates should help ease some of the pressures on individuals’ finances, by lowering borrowing costs. At the same time lower inflation means that some more wiggle room may open up in household budgets. With the hope that the worst of the cost of living crisis is behind us, those who have been saving cash in anticipation of more pain to come could feel like they are now able to spend it. This means that consumer-facing companies, such as retailers, housebuilders and DIY companies that have a large presence in the UK could benefit from more consumer confidence and spending on the high street. This is particularly true for retailers selling large items where consumers have deferred their purchases in recent years, from a new sofa, to a new kitchen or furniture.
“Housebuilders could also benefit from this trend, particularly with the new government’s recently announced housebuilding targets, as lower interest rates equal lower mortgage rates and put more optimism back into the housing market. We’ve seen this optimism play out already, with the FTSE 350 Construction and Materials index rising by 51.5% since the end of October last year, compared to a 16.2% rise in the FTSE 350 index as a whole.
“Another option for those willing to take more risk is to look at heavily-indebted companies. The logic here is that the market could become more hopeful that financial pressures on businesses have softened slightly and, with interest rates dropping, the cost of borrowing for these firms will also ease. However, this is likely to be a short-term rally and is only suitable for those willing to risk losing money, as it’s more speculative.
“On the flip side, there are certain stocks and sectors that will be hit by prolonged interest rate cuts. One group is banks, which tend to benefit from a higher interest rate environment due to the margin they make on interest rate rises. As rates are cut this margin may deplete. However, we’re not expecting the Bank of England Base Rate to drop to its previous lows, meaning banks are likely to be protected from the record low rates we saw in the last decade. On top of this, banks should benefit from fewer defaults on loans, as businesses and individuals see borrowing costs drop and are less likely to miss payments.”
Bonds
“Bond markets have been volatile in recent years as interest rate expectations across the globe have bounced around, but generally interest rate cuts push up bond prices. The coupon on offer becomes more valuable as interest rates drop, pushing up prices. While this means yields will drop, it does give opportunity for investors to sell bonds and realise capital gains.”
Gold
“Gold could be another beneficiary of interest rate cuts. Generally, as interest rates rise and the return on cash increases, gold becomes less attractive because it has no yield. But, as rates start to fall and cash returns drop, gold could become more attractive to investors once again. On top of that interest rate cuts in the US, when they materialise, will push down bond yields and mean a weaker US dollar. Both these factors could make gold more attractive, with gold prices tending to move in the opposite direction to US government bond yields and the US dollar.”
