What to Invest in When Interest Rates Fall

After rising at their fastest pace in decades, the rate hiking cycle appears to be over, with many central banks beginning the process of loosening monetary policy. With interest rates forecast to come down further in the months to come, what does this mean for investors?

In this article, we will explore the effect of interest rates on investments and consider what to invest in when interest rates fall.

What Is the Effect of Interest Rates on Investments?

Interest rates can affect different investments in different ways. Lower rates generally encourage investment in riskier assets, as the return generated from keeping cash in the bank decreases. The opposite is also true.

Let’s take a closer look at how lower interest rates could affect two of the main asset classes: stocks and bonds.

How Interest Rates Affect Stocks

First up, we’ll consider how interest rates affect stocks. Generally speaking, interest rates and stocks tend to have an inverse relationship. In other words, falling interest rates tend to be beneficial to stocks, whilst rising interest rates are not.

However, it is not quite as straightforward as that. Rising interest rates do not automatically depress stock prices – in fact, some stocks stand to benefit from higher rates - just as falling rates will not automatically cause the stock market to soar.

To understand why lower interest rates can improve the outlook for stocks, we must consider three factors:

1. Lower interest rates decrease the cost of borrowing. This may encourage businesses to borrow money to invest in future growth whilst also decreasing the servicing costs for companies which have existing debt. Lower costs can lead to an increase in profitability. Higher profitability and increased investment in future growth can boost a company’s prospects.
2. Lower borrowing costs are not only felt by businesses. Consumers will be more likely to borrow money to fund big ticket purchases and those with existing debt should see their discretionary income rise as the cost of servicing that debt falls. Both these things can lead to an increase in consumption which, in turn, will benefit businesses.
3. Lower interest rates means that consumers are less incentivised to save money, as they will receive less interest on their deposits. As well as an increase in consumption, this also improves investor sentiment, increasing the appeal of investing in riskier assets, such as stocks, in order to generate a higher return. Higher demand for stocks will put upward pressure on prices.

How Do Interest Rates Affect Bonds

Unlike stocks and interest rates, the relationship between bonds and interest rates is a lot more straightforward. Bond prices and interest rates have an inverse relationship. When interest rates rise, the price of existing bonds typically fall, and vice versa.

For those unfamiliar with bonds, this might not be obvious, but the logic behind the relationship is fairly logical.

Bonds are what is known as a fixed-income instrument and essentially represent a loan made by the bond’s purchaser to the bond’s issuer. Upon purchase of the bond, the issuing entity undertakes to repay the loan in full by the maturity date along at a predetermined rate of interest (which is either paid in the interim or at the maturity date).

Once issued, the bond’s interest rate does not change. Consequently, if the central bank amends base interest rates during the bond’s lifetime, it can make the bond more or less attractive, depending on which way interest rates are moving.

If interest rates fall, this makes existing bonds more attractive than they were when they were issued, as they are offering a comparatively higher return than before. Consequently, the price of existing bonds tend to increase accordingly as demand rises.

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What to Invest in When Interest Rates Fall

So, now we know what the effect of lower interest rates could be on a couple of the major asset classes, what should investors consider investing in when interest rates fall?

Bonds present one option, particularly for more risk-averse investors. As interest rates fall, existing bonds become more attractive and their prices are likely to rise as a consequence. For those unfamiliar with investing in the bonds, bond ETFs (Exchange-Traded Funds) can represent a good option for gaining diversified exposure to the bond market.

But what about those who want to capitalise on the potentially positive effect lower rates could have on the stock market?

What Stocks to Buy When Interest Rates Fall?

As discussed, lower interest rates will generally have a positive effect across the stock market as a whole, but some stocks are likely to see more of a benefit more than others.

Small-Cap Stocks

Smaller, younger companies tend to be more sensitive to changes in interest rates than larger, more established businesses.

The logic here is twofold. Firstly, small-cap companies (companies which have a market capitalisation of less than $2 billion) are more likely to hold higher levels of debt with variable interest rates, as well as having less cash on their balance sheet. Therefore, small-caps tend to benefit more from lower rates, as the cost of servicing their debt falls and pressure on their balance sheet eases.

Secondly, investment in these types of stocks is perceived as being higher risk. As interest rates fall, investors’ appetite for risk tends to increase as they seek higher returns. Consequently, demand for riskier stocks generally increases, which can have a positive effect on share prices.

One way to attempt to benefit from this might be to look at small-cap ETFs which track indices composed of small-cap companies. The iShares S&P Small-Cap 600 UCITS ETF is an example of such an ETF.

Consumer Discretionary Stocks

We identified earlier that one of the effects of lower interest rates is that consumers end up with more money in their pockets. This will benefit some companies more than others.

When budgets are squeezed, consumers will prioritise spending on essential, or staple, items. However, as discretionary incomes increase, consumers have more money to spend on things that they want but don’t necessarily need.

This will benefit companies which produce these so-called discretionary items, which are known as consumer discretionary stocks. Investors could try to take advantage of this by investing in a company which would stand to benefit from an increase in discretionary spending, such as Amazon or the Walt Disney Company.

Housebuilding Stocks

Earlier, we looked at how lower interest rates could affect stocks and bonds. Another asset class we could have examined is property. Lower interest rates equate to cheaper mortgages, which can boost optimism and stimulate demand in the housing market.

Who could benefit from an improving property market? Housebuilders for one, who could see a higher rate of completions and sales as mortgage rates drop from higher levels.

Persimmon is an example of a UK housebuilder which could benefit from a lower rate environment.

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