Where to Invest When Interest Rate Falls

The Bank of England has just made its first interest rate cut in more than four years, signaling the beginning of a new phase for the UK economy. While we’re not expecting rates to return to the ultra-low levels of the past, small and gradual cuts are likely over the next year or so. With inflation cooling and the era of high interest rates behind us, investors are now wondering what falling interest rates will mean for markets and how best to position their portfolios.

What Do Falling Interest Rates Mean for Markets?

In general, lower interest rates tend to make investing in the stock market more attractive compared to holding cash. When interest rates are high, savers can get a reasonable return on their cash through savings accounts or fixed-term deposits, reducing the appeal of stocks. But as interest rates fall, returns on cash savings decrease, leading more investors to move their money into equities. This shift can push up stock prices, benefiting the broader market.

However, not all stocks will rise equally, and some sectors may outperform others in a falling interest rate environment.

Small Cap Stocks: An Opportunity?

Small-cap stocks, which are often overshadowed by larger, more stable companies, may benefit from lower interest rates. Though these stocks have underperformed for a while, they have recently shown signs of recovery. Since last autumn, the FTSE UK Small Cap index has surged by 24.9%, outpacing the 14.9% rise in the FTSE 100. This suggests there may be more potential growth in small caps as interest rates continue to fall.

However, investing in small-cap stocks comes with higher risk. These stocks tend to be more volatile than larger companies, offering the potential for greater returns but also exposing investors to greater market swings. For most retail investors, a more reliable and accessible way to invest in small caps might be through index-tracking ETFs. These funds offer diversified exposure to small-cap stocks, reducing some of the risk associated with individual stock picks.

Consumer-Focused Sectors: Poised to Benefit

Lower interest rates often mean cheaper borrowing costs, which can boost consumer confidence and spending. This is good news for companies that rely on consumer spending, particularly those in retail, housebuilding, and other consumer-facing industries. As borrowing becomes more affordable and household budgets stretch further, we may see a rebound in consumer demand for big-ticket items like furniture, home renovations, and even new homes.

Housebuilders, in particular, could see a strong recovery. With interest rates dropping, mortgage rates are likely to follow suit, which could reignite optimism in the housing market. Additionally, the government’s recent push for new housing targets could further support this sector. Since October of last year, the FTSE 350 Construction and Materials index has climbed by an impressive 51.5%, compared to the 16.2% rise in the broader FTSE 350 index. This trend could continue if lower interest rates encourage more people to buy homes.

Heavily Indebted Companies: A High-Risk Play

For those willing to take on more risk, companies in highly leveraged industries could present an opportunity. Sectors such as utilities, real estate, and energy, which tend to carry higher levels of debt, may benefit from falling interest rates, as their cost of servicing debt becomes more manageable. This reduced burden can provide much-needed breathing room, improving their financial position.

However, this remains a speculative play. While lower interest rates can ease short-term financial pressures, they don’t necessarily resolve the underlying challenges these companies face. Investors should approach with caution and be prepared for potential losses.

Which Sectors Could Suffer?

While many sectors will benefit from lower interest rates, there are some that may be negatively impacted. Banks, for instance, tend to perform well in high interest rate environments because they can make a larger margin on loans. As interest rates fall, these margins shrink, potentially hurting profitability. That said, banks are unlikely to see a return to the record-low rates of the past decade, which means the impact may be more moderate. Additionally, lower rates should reduce loan defaults, which could offset some of the lost revenue.

Gold: A Renewed Opportunity?

Gold could also benefit from falling interest rates. When rates are high, cash and other interest-bearing assets become more attractive because they offer a guaranteed return, whereas gold provides no yield. However, as interest rates drop and cash becomes less rewarding, gold may become a more appealing investment.

Additionally, falling rates in the US are likely to weaken the US dollar, which historically boosts gold prices due to their inverse relationship. Beyond economic factors, geopolitical instability, such as tensions in key regions or trade disruptions, could further increase demand for gold as a safe-haven asset.

That said, it’s important to note that gold is already at or near historical highs. While there could still be upside in the event of further volatility, this may not be the best entry point for investors. Investors should weigh the risks of entering the market at such elevated levels.

Conclusion: Preparing Your Portfolio

While we’re still early in this interest rate cutting cycle, now could be a good time to start preparing your portfolio for different market conditions. Small cap stocks, consumer-facing companies, and even certain bonds and commodities may all present opportunities in a falling interest rate environment. However, it’s important to remain cautious and avoid making drastic changes based solely on short-term market movements. 

Diversification and buying at the right (low enough) price remain essential strategies for managing investment risk. By spreading your investments across various asset classes and sectors, you can better position yourself to capitalize on different market conditions while reducing potential downside. Additionally, securing assets at a favourable price allows for a larger margin of safety, and enhance your potential returns. While falling interest rates may present opportunities, they can also introduce new risks, so ensure your portfolio is well-prepared to handle both scenarios.

*This blog should not be considered financial or investment advice. Please consult with a qualified financial advisor before making any investment decisions, as investments carry inherent risks.

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