Major central banks have started lowering interest rates, with more cuts on the cards before the year is out, and investment experts say it's important to position your portfolios accordingly.
The US Federal Reserve announced its first rate cut in more than four years on Wednesday, reducing rates by 50 basis points to a range of 4.75% to 5%, from a 23-year high of 5.25% to 5.5%.
And the European Central Bank announced its second rate cut of the year last week, lowering the key deposit rate to 3.5% from 3.75%.
Other central banks have also started to bring rates down, including the Bank of Canada, the Swiss National Bank, Sweden's Riksbank and the Reserve Bank of New Zealand.
Central bankers have been monitoring inflation figures closely to help guide these decisions, as they want to ensure price growth continues to slow to a target level, which for many is 2%.
In the UK, inflation held steady at 2.2% in the year to August, according to the latest data from the Office for National Statistics. Eurozone inflation also fell to 2.2% in August, while price growth in the US slowed to 2.5% last month.
However, rate setters also want to make sure they don't wait so long to cut rates, as this slows economies down and tips them into a downturn. Then central banks might start to make faster and bigger interest rate cuts.
As this cycle of lowering rates is now well underway, Hal Cook, senior investment analyst at Hargreaves Lansdown says investors need to prepare their portfolios for these changes.
"Bonds are an obvious choice as their prices are very sensitive to changes in interest rates — as rates come down, their prices usually rise," he says. "They have already rallied strongly over the last few months in anticipation of cuts, but likely still have further to go though, especially on a 12-month view."
Yields, or the income return, on bonds typically move inversely to prices. The yield on the 10-year government bond — known as a gilt — have ebbed lower recently and were trading at 3.85% on Thursday morning. The US 10-year government bond — which is called a Treasury — has also dipped over past few months and stood at 3.69% on Thursday.
Fund picks for rate cuts
Cook says that the managers of the Invesco Tactical Bond (0P0000MUWI.L) fund, Julien Eberhardt and Stuart Edwards, have recently been altering their investments to benefit from rate cuts.
"This is best illustrated by their duration position which, at around seven years, is close to the highest it has been over the last 10 years in the fund," he says.
Duration acts as a measure of how sensitive an investment is to interest rate changes and is measured in years, Cook says: "The higher the duration value, the more sensitive the investment is to interest rate changes."
Over one year, the fund has returned nearly 9%, beating its benchmark of the UK government bonds three-month generic bid yield of 5% and it has a yield of 3.4%.
Jonathan Moyes, head of investment research at the Wealth Club and manager of its portfolio service, highlights the Janus Henderson Strategic Bond (0P0001JUM5.L) fund as another option.
He says: "The investment team, led by Jenna Barnard, are long term believers in 'secular stagnation' — the view that high levels of debt, ageing populations and tech driven disruption will drive developed economies to continue to grapple with the low growth, disinflationary environment that dominated markets before the pandemic and war in Ukraine."
"A return to secular stagnation would see a material move lower in interest rates," Moyes adds.
He says this views has informed the team's sizeable weighting to long-dated government bonds, given that these are highly sensitive to changes in interest rates.
Moyes says the Wealth Club team believe the fund would be one of the biggest beneficiaries of a lower-than-expected interest rate environment in its sector.
On a one-year basis the fund has generated a return of nearly 8%, below that of the 11% average delivered by its Investment Association (IA) strategic bond fund peer group. However, it has a distributing yield of 3.7%.
Investors need to prepare their portfolios as rate cutting cycles get underway. ·Imago, Imago
Infrastructure and property
Another type of investment that Moyes says is expected to perform well when interest rates fall is infrastructure.
The Brookfield Infrastructure Corporation (BIPC) invests in global assets, ranging from gas pipelines to a global container business and data centres.
As with all infrastructure assets, these investments have long lifespans, "with cash flows that can stretch into the decades," says Moyes.
"Higher interest rates are bad news for long dated assets, the discount rates applied to those future cash flows are higher, and higher discount rates mean those cashflows achieve a lower valuation in today’s money."
"If interest rates fall, the reverse is true, you would expect longer term assets like infrastructure to do well."
Year-to-date shares are up 18% and Moyes says this "performance has been driven by the market’s view on the likely direction of interest rates and inflation".
He says that the company should pay a dividend of $1.62 in 2024.
"If BIPC can achieve 6% to 9% dividend growth on top of a 3.9% yield, not guaranteed, it should be a welcome addition to a well-diversified portfolio," he adds.
Property is also a sector that is sensitive to interest rate changes.
Alex Watts, fund analyst at Interactive Investor, says: “As well as potential capital appreciation, income is a key attribute of property investing. Even during periods of market stress, the income return of property has historically comprised a stable and significant portion of the total return."
The TR Property (TRY.L) investment trust is well-suited to access yields from real estate, Watts says.
The trust invests in real estate investment trusts (REITs), as well as shares and securities of property companies and property-related businesses. It also holds direct investments in UK property.
Sector exposure in the trust ranges from French and German offices, to student housing and supermarkets.
Watts says that the trust's manager Marcus Phayre-Mudge, who has run the TR Property investment trust for over 19 years, "looks for strong management teams overseeing quality assets and healthy balance sheets".
The trust has a yield of 4.5% and Watts says it "has an impressive record of growing the distributions year-on-year".
For more cautious investors, Hargreaves Lansdown's Cook suggests looking at multi-asset funds, which have a combination of different types of investments.
One example is the Baillie Gifford Sustainable Income (0P0001JSUH.L) fund which not only has exposure to infrastructure and property, but also to bonds, shares and cash.
"It’s managed by a number of experienced individuals at Baillie Gifford and the diversified nature of the fund means that even if rate cuts have differing impacts on different regions and asset classes, the fund has potential to benefit from them," says Cook.
The fund has returned nearly 10% on a one-year basis, slightly below its sector average of 13%, though it has a yield of nearly 4%.
High-growth companies
Scottish Mortgage (SMT.L) investment trust, also run by Baillie Gifford, is another suggestion from the Wealth Club's Moyes.
"It’s struggled more recently as high interest rates mean many of these high growth companies have struggled to raise money to fuel their growth, leading many to tightening their belts — and their growth expectations — in the process," he says.
However, Moyes says falling rates could provide a number of tailwinds.
"Lower rates should make it easier for these companies to raise money, fuelling future growth, while lower discount rates applied to those future growth prospects mean the present value of these companies should increase, [but that's] not guaranteed," he adds.
Holdings include chipmaker Nvidia (NVDA) and electric carmaker Tesla (TSLA), as well as pharmaceuticals firm Moderna (MRNA) and Facebook-owner Meta (META).
Over one-year, the trust has produced a return of 21%, versus a return of nearly 20% from the FTSE All World index tracker.
Meanwhile, Cook also says that there is value to be found in smaller companies "who may find it more difficult to attract investment or borrow money in a higher rate environment [but] have tended to perform very strongly during rate cutting cycles in the past too".
He says that this part of the UK market is trading on a "significant discount" to larger companies.
Cook highlights the FTF Martin Currie UK Mid Cap (0P00017MZL.L) as a good option in this space.
"Richard Bullas has managed the fund since 2013 and is a UK smaller companies’ expert that we hold in high regard," he says.
Stocks held in the fund include Pets at Home (PETS.L) and housebuilder Bellway (BWY.L).
The Franklin Templeton (FLXI.L) fund has generated a return of 17% over one year, which is slightly below its benchmark of the FTSE 250 (^FTMC) ex-investment trusts index, which is up nearly 20%, though it's ahead of its peer group average return of 17%.
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