The ripple effects of rate cuts

It's clear that the economic temperature has cooled considerably, with inflation falling closer to most central banks’ targets. This sets the stage for what could be one of the most significant economic events of the year: interest rate cuts – particularly in the US.

While that’s likely to be a boon for both businesses and investors, it’s important to remember that the markets can be as unpredictable as they are dynamic. Case in point: the tech stock rally, followed by the global sell-off we saw in early August.

Still, while no one can predict the market, there are general trends we’re likely to see. In this month’s newsletter, we’ll explore what a lower-rate environment might mean for your portfolio.

The far-reaching effects of rate cuts 

Interest rate cuts are primarily used as a lever to stimulate economic growth. By reducing borrowing costs, both consumers and corporations are encouraged to spend more. This infusion of fresh capital typically leads to job creation, improved earnings, and increased economic activity overall.

As the economy gains momentum, investor confidence generally increases, which can shift market dynamics significantly. This optimism often leads investors to seek out higher-yielding, riskier assets, pushing prices up. This change in sentiment is key to understanding potential market movements.

Here’s an overview of how rate cuts might impact different asset classes.

Equities: From blue chips to small caps 

Falling inflation and interest rates should stimulate economic growth (all else being equal). Plus, stock valuations tend to rise when interest rates fall. When the returns on cash-like investments get squeezed, the equity market becomes more attractive, prompting investors to move to riskier assets.

Rate cuts may also lead to a market shift from safer assets to growth-oriented sectors. Different sectors and industries will respond uniquely to changes in interest rates and economic conditions, and recognising these trends is essential for optimising asset allocation and capturing sector-specific gains.

Tech companies often benefit from lower interest rates as cheaper capital makes it easier to fund growth initiatives. So far in 2024, we’ve seen outsized growth in tech valuations – mainly been driven by AI enthusiasm – and rate cuts could support further upside. It’s worth noting, however, that after significant rallies, these high-flyers often face turbulence (like what we saw in early August). Maintain a diversified portfolio to manage potential volatility.

Small-cap stocks in particular may see outsized benefits from rate cuts – reduced financial costs can significantly impact their bottom line. In an economy more flushed with cash and capital, they offer growth potential that shouldn't be overlooked.

Bonds: Short, medium, and long-term prospects H2

The bond market's reaction to rate cuts will be nuanced, varying based on bond duration.

Short-term bonds react quickly to interest rate cuts, with yields decreasing quickly. They offer lower returns but higher liquidity and reduced interest rate risk, making them suitable for conservative investment strategies.

Medium-term bonds strike a balance, adjusting to rate cuts with moderate changes in yield. They offer a middle ground between risk and return, suitable for investors looking for a stable asset.

Long-term bonds respond slower to the impact of rate cuts, but they offer the potential for substantial capital appreciation. These bonds suit investors with a longer time horizon, providing both income and growth opportunities as market conditions evolve.

We’re currently seeing an out-of-the-ordinary, inverted yield curve – where longer-duration bonds yield less. But as rates fall, it’s likely the yield curve will flatten, with the relationship reverting as longer-duration bonds start to provide greater yields.

Alternative investments: Diversifying in a lower-rate environment 

As interest rates trend lower, alternative investments can benefit in various ways, offering opportunities to diversify and potentially enhance portfolio performance.

Private equity becomes even more attractive in a lower rate environment. With reduced financing costs and easier access to capital, there’s more room for large-scale acquisitions and strategic restructuring efforts, potentially leading to higher returns for long-term investors.

Venture capital and angel investing is likely to benefit as well. Startups and early-stage companies can face funding challenges during high-interest periods; lower rates often precede a flourishing of entrepreneurship. The effects may take time to materialise, so there’s an opportunity here for investors to support the next generation of groundbreaking companies.

Private credit – which involves lending to companies outside of traditional banking channels – becomes an essential asset class for yield-seeking investors in a lower-rate environment. Businesses benefit too: lower overall interest rates reduce the cost of borrowing, decreasing default risks.

Your portfolio in a lower-rate world 

As we potentially enter a new phase of monetary policy, it’s likely we’ll see a broad and varied impact across different asset classes, influencing everything from the cost of borrowing to investor sentiment and market valuations.

Each asset class will respond uniquely, so it's important to have an investing strategy that can adapt to these changing conditions. Diversification remains paramount: A well-balanced portfolio across various asset classes can help mitigate risks and capture opportunities.

Our ERAA® investment framework is designed to identify economic regime changes and keep your portfolio well-positioned regardless of the macroeconomic environment. With growth now returning, it’s placed a greater emphasis on equities, and increased its allocations to higher-yielding bonds.