What do interest rate cuts mean for investors?

The Bank of England cut interest rates on 1 August, bringing the base rate down to 5% – the first cut in over four years. Many are now asking what this could mean for investors.

If rates come down further over the months to come, will we see a gradual shift into risk assets as cash and bond yields fall from their recent highs? Will some asset classes like small caps and emerging markets start to pick up? Or, is it too soon for investors to adjust their risk appetite, with recessionary risks still on the horizon?

First, it is important to remember that one interest rate cut does not dramatically alter the investment landscape. The Monetary Policy Committee (MPC) has been clear that it will tread a cautious path ahead – and investors should keep this in mind.

Subscribe to Money Week

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up for Money Morning

Don’t miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Rates tend to rise far more rapidly than they fall – and many commentators have been pointing to the old adage that rates rise like a rocket but fall like a feather. Interest rates are expected to remain elevated for some time yet.

Nevertheless, it is worth assessing the potential impact of further cuts. Barring any shocks, we are on a downward trajectory and the International Monetary Fund (IMF) thinks UK interest rates will fall to 3.5% by the end of 2025.

This is higher than the levels we got used to between 2009 and 2021, however the impact could still be far-reaching.

With this in mind, it is worth asking yourself what the changing macro backdrop could mean for your portfolio. Which investments are poised to benefit from falling rates, and are there any adjustments you should make to capitalize on the long-term economic outlook?

Do bonds remain attractive?

Where bonds are concerned, the impact of falling interest rates is two-fold. Bond prices go up when interest rates fall, but the interest available on new issuances is lower.

For this reason, some active managers took the opportunity to increase the duration of their bond funds as interest rates peaked, hoping to lock in a higher level of income for the long term.

Despite this, there is still a good level of income available in the bond market, particularly compared to its long-term history. UK 10-year gilt yields are just shy of 4% – so lower than their peaks last summer but still high.

Hal Cook, senior investment analyst at Hargreaves Lansdown, says the rate cut from the Bank of England has had a limited impact on the outlook for bonds, as it didn’t come as any great surprise.

“The longer-term expectation has been that rates will be cut from current levels,” he says. “Yesterday’s announcement doesn’t suggest that the time frame for future cuts has dramatically changed, nor that they will be cut much more than previously expected.”

What do falling rates mean for equity markets?

Falling interest rates tend to be good news for equity markets – and equity funds have seen inflows this year.

As the reins start to loosen on monetary policy, the idea is that households have more money in their pocket to spend and businesses have more room to grow. A thriving economy is good for earnings, which is good for shareholder returns – at least that’s the theory.

Most equity markets around the world have been rising this year, fueled by hopes for interest rate cuts. However, equity markets took a turn late this week as recessionary fears started to emerge in the US.

“Weak economic data from the US spooked the market and noted investors there are negative reasons why central banks might cut rates, not simply lowering the cost of borrowing because the rate of inflation is easing,” says Russ Mold, investment director at AJ Bell.

“An economy going through a bad patch is one catalyst for a central bank to cut rates and hopefully stimulate activity,” he adds.

The economic growth outlook is something investors will need to watch closely as we move ahead. Interest rate cuts could prompt investors to increase their risk appetite if they think lower rates will unleash growth – but their strategy for investing in a recession should look quite different.

More defensive assets like high-quality bonds tend to do better in periods of economic downturn.

Will the small cap recovery continue?

If economic growth holds up and recessionary fears are important, then interest rate cuts could prompt investors to gradually increase the risk profile of their portfolio. One way to do this is by moving down the market cap spectrum.

Darius McDermott, managing director at Chelsea Financial Services, thinks small caps could benefit from a falling rate environment. They have already been doing well so far in 2024, after a tough couple of years.

UK small caps tumbled in 2022 and spent much of 2023 treading water, as rising interest rates took their toll. Small caps are particularly vulnerable to rising rates, as they typically have more floating-rate debt than larger companies.

However, as expectations for rate cuts ramped up over the course of this year, small caps experienced a strong recovery. The FTSE Small Cap Index is up more than 8% year-to-date, outperforming its large cap counterpart. The FTSE 100 is up around 7% at the time of writing.

“Historically, small and micro-cap stocks have thrived in falling-rate environments,” McDermott tells Money Week. “Building on this year’s positive momentum, we expect further gains for the sector.”

He adds: “UK small caps, in particular, present a compelling opportunity. Despite history suggesting that they significantly outperform large caps over the long term, especially in recovering markets, they still trade at compellingly low valuations.”

Which sectors could see a change in fortunes?

Opinions diverge on which sectors are likely to reap the biggest benefits from a shifting interest rate environment – much will depend on how fast interest rates fall and how well growth holds up.

We highlighted three areas that could receive a boost.

Wealth management stocks

Brendan Gulston, fund manager at Gresham House, thinks companies in the UK wealth management sector could be set to benefit from a falling interest rate environment.

He describes the sector as a growing market thanks to rising household wealth, an advice gap, and shifting government policy.

The sector has been out of favor recently, in Gulston’s view, as households have reallocated personal cash flows against a challenging economic backdrop.

However, he believes an improving outlook of inflation lower and lower rates could support “a positive flow dynamic” going forwards. “This could lead to material earnings outperformance for businesses with strong operational leverage,” he says.

In the fund that Gultson co-manages, he owns companies like Quilter, Brooks Macdonald and Schroders, which he believes are currently trading at “significant valuation discounts”.

Housebuilding sector

Another area of focus in recent months has been UK housebuilders.

These businesses have struggled in recent years, as construction and borrowing costs have soared thanks to high inflation and interest rates. A tough housing market has also made it difficult to shift homes once they have been completed.

However, as rates fall and mortgage costs become more affordable, the sector could receive a long-term boost.

If the government comes good on its promise to build 1.5 million new homes over the course of this parliament while loosening planning restrictions, this could also bode well for the sector.

Shares in Barratt Developments, Vistry, Persimmon and Taylor Wimpey all rose on news of the Labor election win.

Consumer spending

As long as economic growth holds up, interest rate cuts should boost consumer confidence. As the cost of borrowing falls, households should have more disposable income to spend on the things they enjoy doing.

Gulston says expensive discretionary items could remain challenged – but one area where he sees opportunity is “low-ticket experiential leisure”.

Indeed, families could find themselves spending more on things like eating out and going to the cinema as cost-of-living pressures abate. Three stocks Gulston holds in its portfolio include Loungers, Hollywood Bowl and Everyman Media.

“These companies and areas have delivered strong operating performance despite wider challenges to UK consumers. However, the sector as a whole continues to trade at depressed valuations,” he says.

Gulston adds: “These businesses are not reliant on a rapid uptick in consumer confidence or a wider improvement in macro factors, but if such improvements start to materialize (…) we believe there could be a strong rebound in share price performance as earnings receive an additional tailwind, potentially driving a re-rating from current lows.”