Where to invest as interest rates are cut

2022 was a year of unrelenting rate hikes. In 2023, interest rates plateaued. And in 2024, it looks as though we will finally see interest rate cuts. 

Since the 1960s, there have been 85 easing cycles in G10 economies. This means that past experience gives us a good idea about what generally happens to markets when rates are cut. 

In theory, lower interest rates should be good news for equities. Falling rates boost the economy, providing a boost to earnings, too. They should also feed through to lower borrowing costs, a welcome relief given that the average cost of debt servicing for UK firms has doubled to 6 per cent since late 2021. 

Past performance bears this out. Researchers at UBS looked at US and UK returns since 1900. They found that the annualised return on US stocks and bonds was 9.4 per cent and 3.6 per cent, respectively, during easing cycles, compared with just 3.6 per cent and -0.3 per cent during hiking cycles. UK data since 1930 revealed a similar pattern.

Growth stocks should be particularly well placed to gain from falling rates. They were badly hit initially as borrowing costs rose and a higher discount rate was applied to future earnings. Research from EY suggests that every one percentage point increase in the risk-free rate decreases the present value of corporate earnings by just over 10 per cent, hitting valuations hard. Even value stocks – which, as the chart shows, proved less sensitive to higher interest rates – should gain as central banks start to pivot.

We tend to see some familiar sectoral patterns, too. Banks stood to benefit from a high interest rate environment, and for them, rate cuts are less positive news. Shrinking net margins and a gloomy economic backdrop could put pressure on share prices over the year ahead. Housebuilders could also see their fortunes reversed, this time for the better. Even the spectre of rate cuts was enough to trigger a rally at the end of 2023, as markets were buoyed by the prospect of lower rates reinvigorating the property market. 

History also teaches us that bonds perform well in a falling rate environment. As interest rates fall, coupon payments start to look more attractive, driving up bond prices. If rate cuts do materialise as expected in 2024, bonds should see strong total returns driven by both income and capital gains. 

Why this cycle already looks unusual 

But history can only tell us so much. Analysts at Goldman Sachs looked at previous hiking cycles, and found that, on average, rate cuts in G10 economies come seven months after the last hike. Based on historical precedents, the Bank of England (BoE) and the US Federal Reserve are already running late. 

Rate cuts have tended to be pretty drastic once they begin. In an average cycle, there is two percentage points-worth of easing within the first year of rate cuts. This looks incredibly steep, even against the most optimistic expectations. Fed projections suggest that rates will fall to 4.6 per cent by the end of the year – implying only around 0.75 percentage points-worth of cuts. In the UK, BoE projections imply something similar. While this doesn’t give the full 12-month picture, it already looks as though it won’t be an ‘average’ easing cycle.

What goes up won’t just come down 

Matters are complicated by the fact that when it comes to markets, it won’t just be a matter of ‘what comes up must come down’. Returns will be heavily influenced by the macroeconomic backdrop that accompanies rate cuts, too. Inflation looks set to return to target within a matter of months – but economists are split on whether or not a more severe recession will accompany it. 

A best-case scenario would see a ‘soft landing’, where inflation returns to target but the economy avoids a nasty contraction. This would be a coup for policymakers – and for investors too. Analysts at JPMorgan Asset Management think that a soft landing would be positive for stocks in more cyclical sectors (think industrials and financials) as well as small caps where valuations are currently modest. 

But a soft landing wouldn't be entirely good news. If inflation returns to target but the economy avoids a recession, central bankers will have less reason to ease policy. Resilient demand could also leave rate-setters fearful of inflation picking up again, meaning a more cautious approach to cuts. An uncomfortable tension is emerging: if we do see a soft landing, it doesn’t leave much scope for a lower base rate.

Why some economists foresee a lose-lose situation

Deutsche Bank strategist Henry Allen points out that, historically, we only tend to see rapid cuts if the economy enters a recession, although there have been a couple of exceptions. One was in the 1980s, when rates were eased from far higher levels; the other was around the time of the Vietnam War, when the US economy was buoyed by a sharp increase in defence spending and inflation picked up again as a result. Neither is a particularly convincing mirror of today’s situation. Allen said that we could be in a “lose-lose situation”: if markets expect both big interest rate cuts and no recession, they are likely to be disappointed on one front. 

Tom Stevenson, investment director at Fidelity, thinks that “one of the key questions now is just how much of 2024’s market performance was brought forward into the 2023 Santa Rally”. Markets soared at the end of last year as central banks implied that it was a question of when – not if – rates would be cut. But if that doesn't materialise, we could find that this year’s stock market returns were effectively brought forward to the last two months of last year. Optimism has certainly waned since then. Market pricing now indicates a first UK rate cut in August, instead of June, while traders have long since abandoned hopes of a May rate cut in the US. 

Later cuts could be bad news for bonds, too. JPMorgan Asset Management analysts say that in this scenario, cash could remain a “better option” than government bonds if central banks don’t need to deliver on the interest rate cuts that markets are currently pricing in. But with the UK technically in a mild recession, some economies may yet have to endure a bumpy landing. This means that we could see substantial rate cuts – but at the expense of economic growth. 

Bracing for a bumpy landing 

The US economy still looks resilient, but economists warn against “taking a victory lap too early”. Over the past 12 recessions, US growth in the quarter before the downturn started averaged 3 per cent in real terms, according to the JPMAM analysts. In other words, contractions can come on quickly – and seemingly out of the blue. Recessions are hard to forecast at the best of times, and the analysts warn that long and variable lags from rate hikes could plague the economy for months to come.

Fidelity analysts also think that “the traditional impact of higher rates on the real economy has been delayed rather than abolished”, leaving a mild recession the most likely outcome this year. History bears this out. According to Schroders research, in 16 of 22 cycles, the US economy was either already in a recession when rate cuts started, or entered one within 12 months.

How investors can navigate the transition to lower rates 

Rate cuts accompanied by a recession will offer a less benign environment for investors – but still plenty of opportunities. Historically, stock returns tend to be better when corporate profits don’t have a recession to contend with, but are still positive on average as rates are cut.

Analysts at Fidelity think that it could be easier to make money in shares this year for the simple fact that rate cuts should bolster a wider range of firms. The year-end rally was broad-based, and sectors that proved vulnerable to higher rates (like housebuilders) saw a surge, in addition to the big tech stocks that enjoyed a stronger performance all year.

JPMorgan Asset Management expects higher-quality stocks (those characterised by robust balance sheets and a stronger ability to defend margins) to outperform in a mild recession. They see opportunities in sectors such as industrials and financials, as well as in more traditionally defensive sectors such as healthcare. Fidelity analysts think that the ‘Magnificent Seven’ acted as a defensive safe haven in 2023, and could do so again if economies falter this year.

UK shares could have a better year, too. The FTSE 100 has the highest dividend yield of any developed market, and offers a relatively low correlation to global stocks. JPMAM says that “the relative attractiveness of the UK is likely in its defensive characteristics” in 2024.

Why bonds could stand to benefit

A bumpier landing could also be good news for bonds. Schroders’ research finds that, historically, bond investors tend to do better when rate cuts occur in a recession. Safe-haven demand (especially for government bonds) drives yields lower and bond prices higher. Fidelity says bond investors could have scope to lock in an income that (though down on its peak) is still high by recent standards, and enjoy a capital gain as prices rise further.

Although bond yields are still below current cash rates, investors can view them as a tactical play. If recession does occur, JPMAM suggests bonds could act as an “insurance premium that will pay out handsomely”. But a note of caution. Although it looks as though bonds will play a powerful role in diversifying portfolio returns over the year ahead, the analysts also expect more volatility in the stock/bond correlation over the coming years. This means that, although diversification should be easier to come by in 2024, investors may be tempted to look further afield.

Gold could also benefit from a lower rate environment next year. Because it pays no income, it tends to struggle to compete with other assets when rates are high (albeit you wouldn’t know it from recent price performance); lower rates could see gold look more attractive, as the opportunity cost of holding it starts to decline. It could also perform well in a recessionary environment, thanks to safe-haven demand. Fidelity analysts think that gold might be worth holding in 2024, particularly if the economic outlook turns out to be worse than expected this year.

As the 2023 Santa rally showed, rate cuts tend to be good news for investors – only perhaps not quite as good as some market participants are hoping.

Theory, past experience and the latest central bank rhetoric all suggest that we can’t simultaneously enjoy on-target inflation, substantial rate cuts and continued economic growth this year. There will be some disappointment along the way, as rate-setters delay action, or economies start to stutter. Nevertheless, rate cuts should still provide a more benign backdrop than the steep hikes of the past two years.