How the pros are preparing portfolios for interest rate cuts

The waiting game goes on, but fund managers continue to position themselves for interest rate reductions – both in the UK and worldwide. Research published earlier this year by Bank of America found nine in 10 large fund managers expected central banks to beginning cutting rates within 12 months; many reported they were therefore increasing allocations to riskier assets such as emerging markets and high-growth companies.

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In the UK, it’s still not clear when rates will begin dropping. Some economists had expected the Bank of England’s Monetary Policy Committee (MPC) to make its first move as early as next month. This now looks less likely because the UK economy is growing a little more quickly than the Bank had expected, which increases inflationary pressures. The MPC may also be concerned about persistently high inflation in the US, which could delay interest rate reductions there.

Nonetheless, the consensus view remains that lower rates are on the way. However, a return to the ultra-loose monetary policy that has dominated much of the past 15 years is not on the cards. The expectation is that interest rate cuts will be gradual.

Lower rates will change market dynamics

Moreover, whatever the exact outturn, this shift in direction will change the investment environment too. We may be coming to the end of a period in which the economic backdrop has heightened the risk aversion of most investors. Indeed, Bank of America’s survey of investment institutions suggests this shift may already have begun.

In which case, how should retail investors be positioning themselves for these new market conditions?

Well, conventional wisdom suggests certain areas of the stock market tend to benefit disproportionately from rate cuts. For example, businesses with high exposure to discretionary spending by consumers – in the retail, leisure and tourism sectors, say – should get a boost when falling mortgage costs mean people have more cash in their pockets.

By the same token, lower rates are generally good news for companies with larger borrowings; this works in favour of growth stocks such as technology businesses, where debt levels often tend to be higher.

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Sectors with a record of consistently paying decent levels of dividend income also tend to catch investors’ eye when interest rates come down. The utilities industry is a good example – the high and reliable levels of income it tends to pay out look even more attractive when returns on bonds and cash are lower.

The stocks the pros are targeting ahead of rate cuts

In practice, however, there will be opportunities in many areas as interest rates start to fall. And many fund managers are now looking to take advantage.

Richard Hallett, manager of IFSL Marlborough Multi-Cap Growth, makes the point: “Interest rate cuts are likely to particularly benefit companies we hold whose fortunes are linked to the construction sector, which should be boosted by lower mortgage rates.

“These include Ashtead Group (LSE:AHT), which rents out equipment used by construction companies in the US and UK, and Ferguson (LSE:FERG), which is a leading distributor of plumbing products in the US. Also strongly positioned is Volution Group (LSE:FAN), which supplies the construction industry with market-leading ventilation equipment.”

In a related field, real estate is another sector that could benefit from falling rates, Hallett adds. “We’d expect lower rates to be positive for OSB Group (LSE:OSB), which operates brands including One Savings Bank, a specialist lender to the professional landlord market in the UK. Rate cuts should also assist self-storage business Safestore Holdings Ordinary Shares (LSE:SAFE), which is likely to benefit from increased business if the property market picks up and more people are moving home.”

Is a smaller company comeback on the cards?

Hallett’s other point is that the effect of interest rate reductions will not only be felt on a sector basis; the market capitalisation of companies may also be an important consideration. He explains: “We would expect sentiment towards the UK’s smaller companies to improve as rates are cut. They’re seen as more sensitive to higher interest rates and valuations of many of these businesses fell when rates rose. If rates are cut, we’d expect interest in smaller companies to increase.”

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Investors should also be on the lookout for companies in a position to invest more as interest rates come down, says James Henderson, co-manager of Henderson Opportunities Ord (LSE:HOT) trust, Lowland Ord (LSE:LWI) and Law Debenture Corporation Ord (LSE:LWDB). The returns from such investment can subsequently drive outperformance, he argues.

He notes: “We are prepared for rate cuts by having large weightings in industrials and we’ve met a lot of really good quality UK industrial businesses this year. Most have had a challenging time – rising rates have cut demand – but if rates drop, you’ll see capital spend projects get the go-ahead and these industrial companies will benefit.”

The impact can be dramatic, Henderson added, because the underlying change in sentiment multiplies the effect. “In those circumstances, a pick-up in sales can give profits a real kick, analysts too anchored in recent difficulties are not factoring in this potential; valuations are low, and I don’t think it would take much for people to get excited about these names again,” he said.

Bonds are back

It is also worth remembering that equities are not the only way to play the interest rate cycle – there may be opportunities in other asset classes too. Physical property, as well as real estate shares, is one example. But some bonds may provide interesting potential too.

According to David Ennett, co-manager of the Artemis Strategic Bond I Monthly Acc fund shorter-dated high-yield bonds offer the most attractive risk/reward at present.

He said: “While short high-yield bonds are not directly impacted by rate cuts themselves, the companies that issue them can be. Take UK house-builder Miller Homes – its bonds sold off heavily as interest rates increased in 2022-23 due to fears around mortgage pricing and availability; we thought the sell-off was overdone as we saw value in their resilient business model and asset backing.”

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Ennett’s bond fund manager colleague Jack Holmes echoes the point. “Another benefit of shorter high-yield bonds is that they mostly trade at below 100 cents on the dollar,” he explains.

He adds: “Unlike investment-grade or government bonds, high-yield bonds can be repaid early; the effect for bondholders is a jump up to the 100 cent redemption price, an additional source of return not visible in headline yields which normally assume the bond will only be repaid at maturity.”

There will also be interest rate cut losers

For all these opportunities, however, it’s important to consider the flip side – particularly given the ongoing uncertainty about the extent and timing of interest rate cuts. Indeed, Stephen Anness, manager of the Invesco Select Global Equity Income (LSE:IVPG), urges investors not to try to be too clever.

“At the start of the year, markets were expecting six rate cuts in 2024; now they’re pricing in two – trying to anticipate macro events can cost you more than just sleep,” Anness warns.

He adds: “I’d rather have a portfolio of stocks that can thrive through the economic cycle – whatever the ups and downs. Usually, that means companies with high profit margins, strong cashflows and pricing power from high barriers to entry.”

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As an example, Anness points to Union Pacific Corp (NYSE:UNP), the American railways company, which is a top five holding for Invesco Select Trust Global Equity Income.

“Railroads are critical to US supply chains and will continue to play a significant role in supporting the economy. The resultant volume growth and incremental price gains is likely, in our view, to drive financial performance – whether interest rates fall tomorrow or not,” he argues.

It is an important point. Attempting to second-guess the market is difficult at any time, but all the more so given the ongoing economic and political uncertainties that investors face. Identifying stocks and funds with long-term fundamental strengths – certainly as core holdings for your portfolio – therefore remains important.