How to invest when interest rates fall

As interest rates come down, cash savings will no longer provide a real return, forcing investors to put their cash to work in equities and bonds. 

This is feedback from global asset manager Schroders, whose investment specialists discussed how investors should approach the coming interest rate cuts worldwide. 

Inflation is moderating, and market expectations are building for the US Federal Reserve, European Central Bank, and Bank of England to cut interest rates in June. 

Should deposit rates continue to come down, cash will become less attractive. At the same time, a falling interest rate environment has typically been supportive of bonds and equities.

“Over the next few months, the cash rate is coming down, and so, in order to achieve a higher rate of return, it is time to put cash to work,” Remi Olu-Pitan, head of multi-asset growth and income, said. 

“If you have a long time horizon, history suggests you’ll do pretty well by investing in the markets. Within that, diversify and add a bit of value,” said Roberta Barr, head of value ESG and fund manager. 

While US equities’ valuations are at record highs, the specialists explained that there is plenty of value outside the ‘Big Tech’ stocks and the world’s largest stock market. 

The head of strategic research, Duncan Lamont, explained that the stock market will do very well once the Fed starts to cut interest rates. 

The average return above inflation 12 months after rate cuts begin is 11%. Government bonds outperformed by 5% and corporate bonds by 6%, versus a 2% real return from cash. 

Olu-Pitan said equities’ performance after rate cuts will be strong despite the US market’s near-record highs, as there is good value in companies other than the tech giants that have driven market returns lately. 

“The US was the only game in town, but not anymore, and the Bank of Japan maintaining negative real yields, despite raising interest rates, really highlights this,” Olu-Pitan said. “It is time to look at the solid companies outside of the US.”

However, Lamont and Barr think there are still opportunities in the US among the Big Tech stocks and outside them.

“The US looks very expensive because the Magnificent Seven companies are quite expensive. If, instead, you look at valuations of the equal-weighted version of the market, actually, it’s not as expensive,” Lamont said. 

The Magnificent Seven are the US tech giants Apple, Microsoft, Google, Meta, Amazon, Nvidia and Tesla. 

Lamont said investors cannot wait for the US market to retreat from all-time highs to invest despite feeling uncomfortable and intuitive, thinking it is too expensive to invest. 

Over the long term, the market will increase, which means it will hit all-time highs fairly regularly. “So, whilst it feels hard, you would have done better if you’d invested when the market was high than if you hadn’t,” he said. 

According to a study, if you had sat in cash whenever the US stock market was at an all-time high, waiting for it to fall back before investing, you would have destroyed 90% of your wealth. 

Over a 10-year period, such a strategy would have destroyed about a quarter of your wealth; over a 20-year period, about a third of your wealth; over a 30-year period, it would have destroyed about 50%.

“Beneath the massive outperformance of the S&P 500, you have a lot of companies in normal cyclical troughs on huge valuation discounts,” Barr said. 

As a value investor, Schroders is beginning to see some good opportunities. 

“We have these quite high-quality, cash-generative, pretty robust businesses that aren’t the Magnificent Seven, which you’re getting at a real discount today.”  

The large representation of technology stocks and the emergence of AI are key reasons for the US to outperform its peers, and Schroders expects this theme to continue. 

However, this year, markets in Taiwan and Korea are doing just as well because of the high representation of technology and semiconductors, which links them to AI. 

Outside the US, the floor for inflation is likely to be much higher than expected, which tends to be quite good for the industrials and the companies focused on activity and trade. 

This supports Europe and is one of the reasons why Europe’s market is coming back, despite all the pessimism around European growth. This trend is also somewhat supportive of Japan.