Who wins from lower interest rates?

If the predictions are right, the Federal Reserve is likely to announce an interest rate cut when it meets on the 17th September. While recent cuts from the ECB and Bank of England are important, the Federal Reserve is key and will finally turn the corner on an era of high interest rates and persistent inflation.

Although the cut is likely to be small – probably just 0.25% – it will signal an important change of direction. Borrowing costs will fall, cash won’t be as attractive, and the income available from bonds will drop. If interest rates were falling because the economy was weak and central banks needed to give it a boost, this might be cause for concern, but as it is, this should be a good environment for stock market investment.

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But which areas will benefit most? Equity income often loses its appeal when interest rates are high. If investors can get 5% on a savings account, investing into the stock market to get dividends doesn’t hold the same appeal. In reality, there is always an advantage to investing in company dividends over a savings account because dividends tend to grow with inflation, but risk-averse investors are drawn to the security of cash.

Lower cash savings rates push savers towards other options. Global and UK equity income options may benefit as cash rates come down. Investors who are being pulled reluctantly out of cash may want to look at funds such as the Fidelity Global Dividend fund. Dan Roberts manages the fund as a core holding and aims to protect capital in falling markets. The yield is relatively low, at 2.6%*, but investors can expect it to rise over time.

UK equity income used to be everyone’s favourite sector, but its popularity has waned over the past few years. Nevertheless, it’s been a top performer for the year to date. Adrian Frost, manager of the Artemis Income fund, believes the tide might be turning: “The fact that an increasing number of international investors are showing up on UK shareholder registers – not just in the larger global businesses listed here in London, but also in the more domestic areas of the market – suggests that sentiment behind the much-derided UK is beginning to change.

“This also corresponds with the recent acceleration of bids for UK companies, a trend we believe will continue given a UK market which in large parts remains materially undervalued versus international peers. Buybacks remain a powerful catalyst too.”

The laggards

There are a number of areas that have had persistent headwinds as interest rates have risen. These are areas such as commercial property and infrastructure, which are disproportionately impacted by interest rates. There are signs of life for these funds as the direction of interest rates changes.

The RICS Commercial Property Monitor for Q2 2024 said the UK sector was “either at the bottom of the cycle or in the early stages of an upturn”. There was particular strength in certain areas, such as the London office market**. With valuations still depressed across commercial property, there is a real opportunity for a revival if sentiment changes.

Jason Yablon, fund manager of the Cohen & Steers European Real Estate fund, is optimistic. He says: “Interest rates—which dictate the financing costs of real estate—are a key driver for real estate asset values and the returns from Real Estate Investment trusts (REITS). Lower interest rates reduce borrowing costs for REITs, enabling them to finance acquisitions and developments more cheaply and support asset values… falling rates typically increase the attractiveness of REIT dividend yields, compared with other fixed income securities”.

It is a similar picture for infrastructure – those funds that invest in schools, hospitals, pipelines and data centres. Infrastructure assets tend to throw off a regular income linked to inflation. They have continued to do that, but that income has been less valuable at a time of higher rates and funds have performed poorly. This should change as interest rates start to come down.

Data from Franklin Templeton, who manage the FTF ClearBridge Global Infrastructure Income fund, shows that infrastructure has a record of outperformance after rate hikes. Five years out, global listed infrastructure funds have on average returned 90% against 52% for global equities as a whole***.

Smaller companies

Smaller companies always struggle during periods of higher rates. There is a prevailing view that higher borrowing costs disproportionately affect small companies. Equally, the uncertain economic climate created by higher interest rates makes it more difficult for smaller companies to increase their revenues and profits.

This is more perception than reality – many smaller companies have continued to perform well – but their share prices have been very weak. Falling interest rates may help with the perception problem. Smaller companies have already started to recover: they are the fourth best performing IA sector for the year to date^. Simon Moon, manager of the Unicorn UK Smaller Companies fund, says: “The reemergence of inflation in 2021 created an exceedingly difficult environment for smaller quoted companies. A reversal in direction for interest rates should provide a much more supportive backdrop for small-cap investors, despite the bleak geo-political backdrop.”

Perhaps the most important factor in low interest rates is that it makes it more important to invest. Cash rates have already started to fall, and are likely to fall further as more rate cuts come down the track. In this environment, the income and capital growth available from stock markets is likely to become more valuable.

*Source: fund factsheet, 30 June 2024
**Source: RICS UK Commercial Property Monitor, Q2 2024
***Source: Franklin Templeton, Three investment ideas for falling rates
^Source: FE fundinfo, 4 September 2024

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.