On August 1, the Bank of England cut interest rates to 5%, the first reduction in over four years. This has left many investors wondering how such a shift will affect their portfolios. If rates continue to fall, will we see a shift towards riskier assets like small-cap stocks or emerging markets? Or, is it too soon to adjust with recessionary concerns still lingering?
While one rate cut may not drastically change the investment landscape, it’s important to consider its impact. The Bank of England is expected to proceed cautiously with further cuts. Historically, rates rise quickly but fall slowly, and experts predict UK rates could reach 3.5% by the end of 2025. While this is higher than the ultra-low levels of the last decade, it still represents a significant shift in the financial environment.
Do Bonds Remain Attractive?
Falling interest rates typically lead to rising bond prices, but new bonds offer lower yields. Some managers took advantage of peak rates earlier this year, increasing the duration of their bond portfolios to lock in higher yields. However, UK 10-year gilt yields, though lower than last summer, remain attractive at just under 4%.
Hal Cook, senior investment analyst at Hargreaves Lansdown, believes the recent rate cut hasn’t drastically changed the bond outlook. While rate cuts can drive bond prices higher, they also mean that new bonds will offer lower yields, so the income available may be more modest moving forward.
What Do Falling Rates Mean for Equity Markets?
Falling rates generally benefit equities by lowering borrowing costs for businesses and increasing disposable income for consumers. The expectation is that lower rates will stimulate economic growth, boosting corporate earnings and shareholder returns. Equity funds have seen inflows in 2024, as investors bet on a positive economic outlook.
However, the relationship between rates and equities isn’t always straightforward. Weak economic data from the US has raised concerns that central banks may cut rates to combat slowing growth, not just to curb inflation. Russ Mould, investment director at AJ Bell, notes that rate cuts can be a response to economic downturns, which could dampen overall market performance. Therefore, while falling rates can make stocks more attractive, investors should be cautious if recession risks continue.
Will Small-Cap Stocks Recover?
Small-cap stocks, which are more sensitive to rising rates due to their higher levels of floating-rate debt, may benefit from falling interest rates. After a tough 2022, UK small-cap stocks have performed well in 2024, with the FTSE Small Cap Index up over 8% year-to-date, outperforming the FTSE 100.
Darius McDermott, managing director at Chelsea Financial Services, highlights that small and micro-cap stocks tend to perform well in falling-rate environments. “Historically, small and micro-cap stocks have thrived in falling-rate environments,” he explains, adding that UK small caps are trading at attractive valuation discounts, making them a compelling opportunity.
Which Sectors Could See a Boost?
Several sectors could benefit from lower rates, depending on the pace of the cuts and the broader economic outlook:
Wealth Management Stocks
Brendan Gulston, fund manager at Gresham House, believes that UK wealth management stocks could see a boost. The sector is benefiting from rising household wealth and an increasing demand for financial advice. Lower inflation and interest rates could lead to increased demand for financial services, with companies like Quilter, Brooks Macdonald, and Schroders trading at attractive valuation discounts.
Housebuilding Sector
UK housebuilders have faced difficulties due to high borrowing costs and inflation. However, as rates fall, mortgage affordability improves, which could drive housing demand. If the government delivers on plans to build more homes and ease planning restrictions, housebuilders could benefit. Companies like Barratt Developments and Persimmon have already seen improvements as expectations for rate cuts grow.
Consumer Spending
Lower interest rates can boost consumer confidence and spending. As borrowing costs decrease, households will have more disposable income to spend on leisure activities. Gulston points out that “low-ticket experiential leisure,” such as dining out and cinema visits, could see growth. Stocks like Loungers, Hollywood Bowl, and Everyman Media, which operate in this space, could benefit from increased consumer spending.
AI in Finance and Business Loans
In addition to sector-specific opportunities, AI in finance is reshaping the industry. Companies leveraging AI for finance strategy, profitability, and asset finance could gain a competitive edge. AI can also streamline finance benchmarking and improve efficiency, making firms more attractive to investors.
As interest rates fall, business loans may become more accessible, benefiting companies seeking financing for growth. The insurance sector could also see increased demand as borrowing becomes cheaper for consumers and businesses alike.
For stockbrokers and financial advisors, the rate environment presents both opportunities and challenges. Investors may seek advice on adjusting their portfolios, and professionals who can navigate the changing landscape will be in high demand.
Conclusion
Interest rate cuts present both challenges and opportunities for investors. While falling rates can make bonds more attractive and boost equities, particularly small-cap stocks, caution is needed if recession risks persist. Sectors like wealth management, housebuilding, and consumer spending could see a boost, while AI and emerging technologies in finance are reshaping the industry. Investors should stay informed and adaptable, adjusting portfolios as rates continue to shift.
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