Funds for a falling interest rate environment

The cost of borrowing increased in both the US and the UK in November, as government bond markets moved to discount a slightly hotter inflation environment. Donald Trump’s second term in office will begin at a time when the US economy has already been surprising to the upside. Intended policy shifts to restrict immigration, raise tarrifs and cut taxes would likely lead to higher inflation.

A similar pattern has emerged in the UK following Labour’s Budget. Raised public borrowing to fund increases in spending could prove inflationary. On the other hand, this possibility needs to be set against the likely effects of a rise in employer National Insurance contributions, which could lead to reduced wages growth or even job cuts.

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Set against these events too are higher bond yields – these could act to cool the economy over the short term. Moreover, with inflation close to its 2% target rate in both the US and the UK, further reductions in interest rates remain on the cards.

Remember, rates got as high as they did in 2023 due to an extraordinary combination of factors that had driven inflation to unusually high levels. These factors included high energy prices, supply chain disruptions, the war in Ukraine and worker shortages after the pandemic.

Interest rates forecast

The US Federal Reserve has cut its key interest rate three times since September and markets currently indicate there’s a slightly better than 50% chance we shall see a further cut in December¹. That’s even after Fed Chair Jerome Powell said in mid November that America’s central bank does not need to be in a hurry to cut rates further.

Here in the UK, interest rates have been reduced twice so far – in August and November. A rise in inflation to 2.3% in October, partly due to increases in household energy bills, may mean we have to wait until next year to see further cuts. The latest from the Bank of England is that the Bank Rate (currently 4.75%) is expected to fall to around 3.7% by the end of next year².

• Read more: how far will interest rates fall?

What happens when interest rates go down?

Lower interest rates affect markets in two main ways. First, they have a material impact on the earnings capabilities of businesses by reducing borrowing costs both for 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 they lead to higher inflation.

Bonds have proven quite volatile around the US election, as markets have tried to get a grip on the likely economic effects of the policies of the next administration. The yield on benchmark 10-year US Treasuries is 4.4% today compared with 1.8% back in February 2022 just before short term interest rates started to increase³. Since bond yields move inversely to bond prices, this suggests there is still upside potential as we move further away from the extraordinary conditions of two years ago.

Funds for a lower interest rate environment

Fidelity’s Select 50 list currently contains ten bond funds. 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 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 3.9%, which is not guaranteed⁴.

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

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, Nvidia  etc. – among the largest holdings⁵.

In effect, global, passively managed funds have turned into momentum plays on the US. That’s because they’re automatically skewed 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 has been among the winners of 2024, even though rate cuts have, so far, failed to lead to a weaker dollar. Ordinarily, gold struggles against a strong dollar, because it makes it more expensive to buyers in other currencies.

The iShares Physical Gold ETC features on the Select 50. This exchange traded commodity (ETC) is included 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.

Back in the UK, lower interest rates should benefit equity income funds. One of the big challenges for income investors over the next year to eighteen months will be how to replace the lost income from cash 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, it also offers the possibility of exchanging a falling income for one that rises over time.

The UK stock market currently yields about 3.7% and many equity income funds about a quarter more. These yields will become even more attractive on a relative basis as cash rates continue to fall back⁶. Please note these yields are not guaranteed.

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 48 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 4.7%, an amount that is not guaranteed⁷.

Source:

¹ CME FedWatch, 19.11.24
² Bank of England, 07.11.24
³ Federal Reserve Bank of St Louis, 19.11.24
⁴ Colchester Global Investors, 31.10.24
⁵ LGIM, 30.09.24
⁶ London Stock Exchange, 19.11.24
⁷ Franklin Templeton, 31.10.24

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.