At the end of last year the market was pricing in 1.7% worth of US rate cuts for 2024 but here we are in late August and the Federal Reserve is yet to pull the trigger, largely due to stickier-than-expected inflation.

However, after a series of false dawns, we may finally be approaching the point where the Fed acts, with a rate cut widely expected on 18 September. The debate largely centres on whether the central bank cuts rates by 25 basis points (0.25%) or opts for a big 50 basis-point (0.5%) move.

This matters outside of the US. The world’s largest economy inevitably has the world’s most influential central bank and, while its counterparts in the UK and Europe (and elsewhere) have already started the rate-cutting process, when the Fed cuts it could really shift the dial. 

Ahead of this major market milestone, Shares has canvassed the opinion of myriad market experts to get an impression of how different stocks, sectors and asset classes might react.

WHAT IS THE LIKELY TRAJECTORY OF RATES?

First, it is worth considering what the trajectory of rates may look like. Some forecasters think we might see two rate cuts before the year is out, while Bank of America notes a big driver for cuts could be the state of the US public finances.

National debt across the Atlantic is up more than $1 trillion so far in 2024 to $35 trillion with the annual interest payment at $900 billion, accounting for 13.4% of government spend.

If rates were left unchanged then Bank of America sees this figure rising to $1.4 trillion by July 2025, and even if there are 200 basis points worth of cuts in the interim payments would rise to $1.2 trillion. As the investment bank concludes the net result is ‘many Fed cuts a-coming’.

The consensus view is for rates to end 2025 at around 3.75%. While lower interest rates are usually perceived as good news for stocks, as the relative appeal of lower-risk assets like cash are reduced, the portents are actually not great for the markets based on what has happened in the last few rate-cutting cycles.

However, it is worth adding that these were accompanied by significant crises, namely the dotcom crash, the great financial crisis and the pandemic.

Much will depend on whether the Fed has been able to engineer a soft landing for the US economy, steering it through an inflationary period with a restrictive policy without inflicting too much economic damage.

While the US consumer has proved impressively resilient and growth has largely held up, interest rate hikes have a lagged effect and the full impact of the surge in rates which started in late 2021 may not be felt until we are already well into the rate-cutting cycle.

Charles-Henry Monchau, chief investment officer of boutique Swiss bank Syz Group, observes: ‘It all depends on which type of rate cut(s) we get. There are historically three types of Fed cuts: "panic cuts", "soft cuts", and "hard cuts".

‘Panic cuts, such as those in 1987 and 1998, are positive for stocks if the event does not impact Main Street. Soft cuts, like those in 1984, 1995 and 2019, are positive for both stocks and bonds. Hard cuts, as in 1973, 1974, 1980, 1981, 1989, 2001 and 2007, are negative for stocks but positive for bonds. Therefore rate cuts are not always positive for stocks.’

BETWEEN A HARD AND A SOFT LANDING

Paul Middleton, senior global equities portfolio manager at Mirabaud Asset Management, says: ‘We have just witnessed a very rapid fall in US yields. There have been two distinct periods of stock performance during this decline, and this gives us a very good feel for how stocks will behave around rate cuts.

“The first part of the decline in yields was accompanied by data suggesting a soft landing: slightly weaker inflation reported against expectations, and slightly stronger than expected employment. In this soft-landing phase, recovery names worked well – names that tend to perform strongly as we are exiting a macro slowdown period, such as housing-related companies, or autos.’

‘The second part of the decline in yields saw the narrative switch from soft landing to hard landing, with weaker inflation and weaker employment. There has been a significant and rapid move into safe haven names – staples, utilities, healthcare, and REITs.

‘The market narrative has shifted rapidly between these two extremes, and the truth will likely fall somewhere in between. History suggests a soft landing is a much less likely outcome of the two, and markets tend to stay defensive post first cut, so within the portfolios we have a slightly more defensive tilt than usual, but as always we keep some attackers on the pitch for when the macro data turns.’

Darius McDermott, managing director of Chelsea Financial Services, observes: ‘Anticipation of global interest rate cuts has already fueled a broader risk asset recovery this year. The interest rate cut by the Bank of England is significant and will likely embolden investors to increase their level of risk. With the Fed widely expected to follow suit in September, the stage is set for a surge in “animal spirits” in markets.’

WHAT RATE CUTS MEAN FOR THE PROPERTY SECTOR AND REITS

Rich Hill, head of real estate strategy and research at US asset manager Cohen & Steers, says: ‘Over the past several years we have seen some of the largest and fastest interest rate increases in more than 40 years. This has negatively impacted global REITs (real estate investment trusts) over the last two years with the sector down 12.2% from its peak in 2021. However, efforts by global central banks to bring down inflation are working, and we believe we are moving towards a macroeconomic environment that should be more accommodative to listed REITs as interest rates are potentially cut.

‘This, coupled with fundamental growth which remains on a solid footing, and valuations which are attractive relative to equities, sets the stage for the listed REIT rally to continue. Indeed, globally-listed REITs have risen almost 32% since their post-Covid lows in the fourth quarter of 2024.

‘In fact, US-listed REITs are the second-best performing sector of the S&P index over the last four months. We expect to see more volatility as global central banks try to navigate a soft landing, and we believe pullbacks can act as entry points, while volatility may provide active managers with opportunities to outperform.

‘Within the US, we like data centres, senior living facilities, single-family rentals and cell towers. In Europe, we favor high-quality continental retail, logistics, self-storage and cell towers, which offer attractive valuations and solid fundamentals or relatively attractive pricing. We also like the German residential sector as values stabilise and discounts to NAV (net asset value) are historically wide.’

SMALL-CAPS TO SHINE?

McDermott notes that, historically, small-caps have performed well when rates fall and he expects this space to build on its recent momentum.

‘Despite history suggesting they considerably outperform large-caps over the long term, especially in recovering markets, they still trade at compellingly low valuations,’ he adds.

McDermott highlights ‘talented stock pickers’ who can take advantage such as Liontrust UK Smaller Companies (B8HWPP4), WS Amati UK Listed Smaller Companies (B2NG4R3), and Unicorn Smaller Companies (3178506) funds.

There isn’t necessarily a consensus on small-caps' ability to shine. T. Rowe Price’s solutions strategist in its multi-asset team, Michael Walsh, says: ‘While expectations the Fed will start to cut rates has hardened, small-cap stocks in the US have advanced sharply in recent weeks. We question whether fundamentals will improve sufficiently to justify this rally.’

McDermott also flags emerging markets as a beneficiary of rates moving lower. ‘While market volatility and uncertainties persist, particularly around China, the sector's compelling demographics – young, growing populations, and expanding middle classes – offer the potential for strong long-term returns. This potential outperformance could also be amplified by the prospect of a weakened US dollar,’ he says.

He highlights FP Carmignac Emerging Markets (BQXJRP9), FSSA Global Emerging Markets Focus (BZ8GV67), and Invesco Global Emerging Markets (3303030) as ‘strong contenders in this space’.

Walsh believes much will depend on the pace and length of the current easing cycle. ‘Rate cuts are expected to continue at a leisurely pace by the markets, as monetary easing helps major economies achieve a soft landing. We see this relatively rosy view as the most likely outcome and maintain a small overweight position to selected areas of the equity market and other risky assets such as high yield debt, as corporate profitability remains strong,’ he says.

GOOD NEWS FOR INVESTMENT TRUSTS?

Nick Greenwood is co-manager of MIGO Opportunities Trust (MIGO), which seeks to take stakes in investment trusts trading below the market value of their underlying assets. With the direction for rates set lower, he believes this is a good time to revisit bombed-out ‘alternative’ trusts.

‘Most of these were created to solve yield starvation by offering a decent dividend at a time when deposit rates were effectively zero,’ he says. ‘Demand has evaporated now it is possible to get a decent income from conventional sources such as gilts. This has led to an oversupply situation and given investment trust share prices are decided by the balance of supply and demand, it is not surprising many of these funds can be acquired at steep discounts. At these depressed levels the dividend yield is high relative to share prices.

‘This represents an arbitrage opportunity as the lack of demand is for the structure whereas the market for the assets the trust owns is often buoyant. Yields on funds such as Cordiant Digital Infrastructure (CORD) and VH Sustainable Energy Opportunities (GSEO) will attract new buyers as a decline in interest rates reduces what is on offer elsewhere.

‘The general oversupply situation is steadily resolving itself via widespread buybacks, returns of capital and mergers. In the not-too-distant future demand will no longer be swamped by supply, allowing shares to trade closer to the value of their portfolios. This should mean share prices will rise even if net asset values make no progress.’

WHAT ABOUT BONDS?

Walsh concludes: ‘It would be a different story for instance if a sharp downturn in the labour market soured sentiment on the economic outlook. Then we would be likely to see a much quicker series of rate cuts and a general flight to quality, boosting high-quality fixed income, such as US treasuries, at the expense of riskier asset classes.’

Typically, when rates go up so do bond prices, although conversely this also means the yields on bonds fall. The co-managers of Aegon Strategic Bond Fund (B00MY36), Alex Pelteshki and Colin Finlayson, say: ‘Going forward, we continue to see an unusual set of opportunities in global fixed income markets. We expect to see the commencement of one of the largest synchronised easing/rate cutting cycles in recent history across developed markets, therefore we maintain an above- average interest rate risk position.’

Interest rate risk is the potential for investment losses triggered by a move upward in the prevailing rates for new debt instruments, and the managers at Invesco Bond Income Plus (BIPS), Rhys Davies and Edward Craven, see a similar picture: ‘There have already been some rate cuts and we think there will be room for more over the rest of the year. We are comfortable holding more interest rate risk. Current yields are satisfactory and there is potential for capital return as interest rate expectations evolve.’

DISCLAIMER: The editor (Ian Conway) of this article has a personal holding in Invesco Bond Income Plus.

‹ Previous2024-08-29Next ›