Funds for a falling interest rate environment

America’s central bank did its best to last week reassure markets that it is in control of the economy, after cutting interest rates by a larger-than-expected 0.5%. It also hinted it will do whatever it takes to keep the US economy on a stable footing. Recent fears have revolved around whether the Fed might have left it too late to save the US economy from a near-term recession.

Current expectations point to an additional 0.5% reduction in US rates between now and the end of the year, making a 1% drop in total. It’s hoped that this will help bolster America’s labour market, while vanquishing any remaining fears the economy is teetering on the brink. Fed Chair Jay Powell was at pains to say “we are committed to maintaining our economy’s strength”.

The initial reaction from markets was muted, suggesting the possibility of a half point cut was largely priced in. However, markets have since responded more positively, with the Dow Jones Industrial Average and S&P 500 both trading up to new record highs.

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The hope now is that markets will be more willing to take disappointing economic data in their stride, including weak figures from the labour market. In any case, a view now seems to be forming that job vacancies may in fact be a poor indicator of the overall health of the economy, given a recent surge in immigration.

In the wider scheme of things we are now probably at the start of a multi-year cutting cycle. This had been anticipated, however. The reason that many shares and bonds have continued to gain ground this year is that markets have been discounting a more favourable environment for companies and more demand for a broad range of assets – shares, bonds, property etc. – as rates fall.

Lower interest rates affect markets in two main ways. First, they have a material impact on the earnings capabilities of companies by reducing the borrowing costs both of themselves and their customers. Lower rates also boost underlying confidence.

Second, lower rates have the capacity to fuel a switch out of cash in favour of shares and bonds. For bonds, falling rates are a very good thing unless lower rates lead to higher inflation. Currently markets seem to view economic risks as tilted to the downside and resurgent inflation is not the central market view.

As such, bond yields might be expected to fall – and bond prices rise – across the maturity spectrum as short term interest rates continue to drop. While bond yields have already fallen in anticipation of future rate cuts, yields remain considerably higher than at the start of the last rate hike cycle. For example, the yield on benchmark 10 year US Treasuries is 3.7% today compared with 1.8% back in February 2022¹.

Fidelity’s Select 50 list of favourite funds currently contains ten devoted to bonds. One such is the Colchester Global Bond Fund. Run by an experienced and stable team of managers, it is focused entirely on government bonds and has low correlations with both equities and corporate bonds. The fund’s lack of exposure to corporate bonds also means it is not exposed to the credit risks of companies, which might increase if the world economy slows from here. The fund currently has a running yield of 3.8%, which is not guaranteed².

The Magnificent Seven technology shares and the technology sector in general also stand to benefit from lower rates. They fell back sharply in 2022 as rates increased, reflecting a change in the relative value of risk-free cash deposits versus companies with the bulk of their profits way out into the future.

Remember, however, that much of the recent disquiet around tech shares has been down to fears about the ability of artificial intelligence (AI) to generate profits for its users. These fears could outweigh the positive effects of interest rate cuts in the near term, even as giant companies such as Microsoft and Google continue to spend big.

From the Select 50, the Legal & General Global Equity Index Fund would benefit from a further recovery in technology shares. It currently has a 28% weighting in tech, with most of the mega-cap names – Apple, Microsoft and Nvidia – among the largest holdings³.

In effect, global, passively managed funds have turned into momentum plays on the US. That’s because they’re automatically skewing towards the market’s previous best performers – most notably America’s Magnificent Seven. This is benefiting investors on the way up, but would have adverse effects if the same companies went into retreat. 

The Brown Advisory US Sustainable Growth Fund is another potential Select 50 option. Like technology shares, the companies that growth funds typically invest in are sensitive to changes in interest rates owing to the long duration of their earnings.

Fidelity’s experts favour this fund for its experienced management and the strong pool of company analysts its draws on. The fund is mostly invested in larger companies with a durable competitive advantage and steady rather than necessarily rapid growth. It also has a focus on quality.

In the alternative assets arena, gold and bitcoin have been among the winners from last week’s rate cut. Both are beneficiaries of a weaker dollar. The former continues to exhibit a strangely strong correlation with Nasdaq technology shares, a characteristic that was never envisaged at bitcoin’s outset, so that’s something to bear in mind going forward.

The iShares Physical Gold ETC features on the Select 50. Fidelity’s experts like this exchange traded commodity (ETC) because it is underpinned by a physical entitlement to gold and because of BlackRock’s success in running this strategy for some time. The gold owned by this fund has been responsibly sourced. It’s worth noting, however, that gold has had a very good year-to-date, and it’s unclear as to how much expectations of falling interest rates have already contributed to this.

For UK investments, the news is less good, as rate cuts stateside make a weaker dollar ever more likely. Already, the pound is trading at around 1.34 versus the dollar – easily the highest level we have seen in the past year⁴.

As a result of this, the FTSE 100 index may suffer, given its high exposure to UK companies with earnings in dollars. Against that, if lower rates lead to a stronger US economy, everyone stands to benefit from that, including investors in the UK. Moreover, a strong pound ought to exert an additional downward pressure on inflation. That, in turn, could make it easier for the Bank of England to reduce interest rates further or faster or both.

A general tendency towards lower rates is positive for the UK’s equity income sector. The UK stock market currently yields about 3.6% and this becomes more attractive on a relative basis as cash rates start to fall back to this level. Please note this yield is not guaranteed.

One of the big challenges for income investors over the next year to eighteen months is how to replace their lost income from savings accounts as rates fall. Investing in shares provides one answer and, while switching from the one to the other entails accepting risks to capital, this also offers the possibility of exchanging a falling income for one that rises over time. So bond proxies and other shares generating attractive dividend returns could see a lot more interest.

The FTF Martin Currie UK Equity Income Fund aims to generate an income higher than that of the FTSE All-Share index plus investment growth over a three to five year period after fees and costs. Among the fund’s 49 investments are holdings in some of the UK’s largest dividend payers, including Unilever, Shell and AstraZeneca, as well as medium sized companies including Cranswick and IG Group. The fund pays a quarterly dividend and currently yields approximately 4.4%, an amount that is not guaranteed⁵.

Source:

¹ Federal Reserve Bank of St Louis, 24.09.24
² Colchester Global Investors, 31.08.24
³ LGIM, 31.08.24
⁴ Bloomberg, 24.09.24
⁵ Franklin Templeton, 31.08.24

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. There is no guarantee that the investment objective of any Index Tracking Sub-Fund will be achieved. The performance of the sub-fund may not match the performance of the index it tracks due to factors including, but not limited to, the investment strategy used, fees and expenses and taxes. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.