Stock markets at records and cash at 5%: what will happen next?

Investors have a lot to celebrate right now. The FTSE All-Share is at an all time-high, at more than 4,580 points, after rising nearly 10% so far this year. Across the Atlantic, the S&P 500 index of America’s largest stocks is also at a record.  

Professional investors, as surveyed by Bank of America, are their most bullish since November 2021, driven by expectations for interest rate cuts.   

• Invest with ii: How Bonds & Gilts work | Tax Rules for Bonds & Gilts | Open a SIPP

Strong stock markets, combined with falling inflation and money market funds paying 5% because high interest rates have proved stickier than expected, mean that investors are being rewarded for being in – and out – of the market.  

But what comes next is what matters. Here, we look at a number of different scenarios experts are thinking about.  

All time-highs lead to more all-time highs 

Investors should not be worried about new market records and the “psychological barriers to entry” they bring, according to research from RBC Global Asset Management. It says that while investing at all-time highs means paying a price that no one has ever paid before – creating a seemingly guaranteed recipe for regret – outcomes are often very good.  

It found that since 1950 the S&P 500 index has set 1,250 all-time highs along the path to its current level. That’s an average of over 16 every year. 

• Sign up to our free newsletter for share, fund and trust ideas, and the latest news and analysis
• Optimism towards UK improves, but pros are not piling in

RBC says that new market highs are not as meaningful as some may think as they are often linked to the continued growth of the economy and corporate profits.  

It found that one year after an all-time high, based on historical data, the S&P 500 had a 9% chance of finishing down more than 10%. Three years out, this drops to just a 2% chance, while five years later there was not a single example since 1950 when markets were 10% lower.  

“Nevertheless, when markets are sitting near all-time highs, many investors still can’t help but feel a bit uneasy about putting new money to work.

“Some investors make the decision to remain in cash and wait for a large correction before they invest. However, often a significant correction never comes, leaving the investor with the regret of missing out on investment returns,” the firm said.  

What about the economy and stock markets?  

While inflation is falling, which is good news for stock and bond prices, investors are still worried that higher interest rates could be here to stay, which would have an impact on asset prices. 

Tom Becket, co-chief investment officer at investment firm Canaccord, says that the market expectation was for several interest rate cuts this year, but recent inflation and economic data has seen this expectation fall to between one and two cuts, with this first this summer. 

Becket says that earlier optimism about multiple interest rate cuts boosted markets, but some may be surprised that markets have been resilient even as forecasts for rate cuts are dialled back.   

There are several reasons markets have been so strong, he says: “Economic activity has been solid, which has boosted expectations for corporate profits. And although it’s proving difficult to get inflation down to the 2% target, investors seem to think inflationary pressures are receding. And although interest rate cuts aren’t what was expected, the next move will almost certainly be lower.” 

• UK interest rate outlook: will Bank of England cut first?
• What needs to happen for fund investors to buy back into the UK?
• FTSE 100 record highs: what does it mean for investors?

Nevertheless, Fidelity International’s multi-asset team sees a pause for positive equity returns and is therefore reducing its equity overweight.  

“Although inflation is sticky, it is not ‘hot’. The Federal Reserve may delay rate cuts, but they will arrive eventually. However, a number of factors including geopolitical risks, extended sentiment and positioning, along with weaker upcoming seasonality, mean that we believe equity markets may pause after a period of strong performance,” the fund manager said.  

Within equities, it prefers US and Japanese shares as it says the US economy and equity market are where the growth is even though valuations might be a little high: “Overall, we prefer quality companies with strong balance sheets,” it said. 

Fidelity International likes Japan because business activities continue to recover especially in the service segment, which has been supported by reopening and tourist flows, while manufacturing is benefiting from tech-related activities. In the UK, it says valuations are still attractive, however the earnings outlook is weak. 

How will bonds perform?  

With UK government bonds, known as gilts, yielding more than 4%, and investment grade corporate bonds at about 5.5%, investors are finally being paid to own fixed-income assets. 

But another advantage is that a peak in interest rates, followed by rate cuts as inflation falls back to central bank targets, could also boost bond prices. 

David Coombs, head of multi-asset investments at fund manager Rathbones, says that government bonds could rally once inflation rates return to their falling trends, even if they don’t quite reach 2% for a while. 

• Fund Spotlight: earn 5% on your cash with this £7 billion fund
• Benstead on Bonds: the four gilts investors are backing – should you too?

“Even with 2.5% inflation, real (inflation-adjusted) yields of 2%+ would be really attractive on a historic basis. And we could see roughly 25% capital gains from the long-duration bonds in our portfolios in a relatively short period of time if prevailing yields fall by one percentage point. Yes, equity-like returns from government bonds,” he adds.  

On the other hand, he says that if the worst happens and rates stay too high for too long, resulting in recessions or no growth, then we could see government bonds rally in anticipation of emergency rate cuts. 

“Equites won’t look great in this scenario (anticipating falling earnings) but bonds could make big double-digit gains and – more importantly – resume their negative correlation to equities and their roles as diversifiers,” he said.  

Is cash attractive? 

Yielding around 5% via money market funds, such as Royal London Short Term Money Market, being out of the market could look appealing.  

However, money market fund yields track interest rates, and with rates set to fall, returns could be lower. On the other hand, bond prices would rise if interest rates dropped.  

Chris Iggo, chief investment officer at AXA Investment Management, says that owning short-duration bonds – which are those maturing soon and therefore have a lower sensitivity to interest rate changes – are a good option.  

“The case for short-duration credit strategies is strongest when compared to cash. Interest rates on cash have peaked and will decline over the next year. When rates are cut, remuneration on cash declines but bond prices rise. So, a short-duration credit strategy benefits from having, today, the same yield as overnight cash rates but also the potential for capital gains when rates are cut and, perhaps, from the further modest tightening of credit spreads,” he said.