Inflation is moderating, and market expectations are building for the US Federal Reserve (Fed), European Central Bank and Bank of England to all cut interest rates in June. Should deposit rates continue to come down, cash will become less attractive, while, at the same time, a falling interest rate environment has typically been supportive of both bonds and equities. Remi Olu-Pitan, Head of Multi-Asset Growth and Income, Roberta Barr, head of Value ESG and Fund Manager, Equity Value, and Head of Strategic Research, Duncan Lamont discuss how investors should respond to the changing investment environment.

How have bonds and equities performed in past rate-cutting cycles?

Duncan Lamont: ‘On average, the stock market does very well once the Fed starts to cut interest rates. The average return in excess of inflation 12 months after rate cuts begin is 11%. Government bonds outperformed by 5% and corporate bonds by 6%, versus a 2% real (inflation adjusted) return from cash. So, investing in the stock market and bonds have produced pretty good real returns, handsomely beating cash in the process.’

Remi Olu-Pitan: ‘The concern of a lot of investors is that the market has already priced in the expected interest rate cuts, with the S&P 500 up 23% since October*. Whilst the market has recovered from what was a very challenging 2022, the idea of equities still doing very well post cuts is very important. When the cuts happen, that opportunity cost of finding places to move into really takes over.’

Has it mattered whether there has been a hard, or soft-economic landing when rates were cut?

Remi Olu-Pitan: ‘Because we expect a non-recessionary rate cutting cycle this is a good opportunity for bonds. On one hand, we have interest rates falling, therefore this supports capital values on bonds and you have less risk around credit spreads. This is because if we avoid a recession then a lot of companies are able to repay their debts. It’s a very rosy environment for corporate bonds.’

Duncan Lamont: ‘Equities have historically done well if a recession is avoided, but even if one is not they’ve still done pretty well in a rate-cutting cycle. This takes away some of that worry that many investors might have. They may be asking themselves “what if I’m wrong?”. Well, actually, if the economic environment turns out worse, stocks on average have still gone on to do pretty well.’

How are you viewing the US equity market versus others?

Remi Olu-Pitan: ‘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. Growth is doing well, inflation is doing well, we’re getting very good corporate governance, this is the time for Japanese equities. I know they have done well, but in our view there is a perfect mix in terms of the macro-economic environment for Japanese equities to do well. It is time to look at the solid companies outside of the US.’

Duncan Lamont: ‘I’ve had a look at the degree of concentration in the US and I’m sure everyone has heard of the “Magnificent Seven”. This group now make up more of the global stock market than the weight of the next five biggest countries (after the US) combined! The US looks very expensive because these 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. There are lots of opportunities to pick up cheaper companies if you do the work.’

How should we look at these markets?

Roberta Barr: ‘Beneath the massive outperformance of the S&P 500, you have a lot of companies in normal cyclical troughs on huge valuation discounts. There’s the saying that it’s always “darkest before the dawn” and actually, as a value investor, we are beginning to see some amazing opportunities. We have these quite high quality, cash-generative, pretty robust businesses, that aren’t the Magnificent Seven, which you’re getting on a real discount today.’ 

Remi Olu-Pitan: ‘There are some clear macro and secular trends that have driven the outperformance of the US relative to other markets, the large representation of technology stocks and the emergence of AI are key reasons for this and this theme will continue to support performance. However, this year markets in Taiwan, Korea are doing just as well because of the high representation of technology and semi-conductors, which links them to AI. That link is important and something investors can’t ignore. It is getting expensive, but the trend is significant.’

Remi Olu-Pitan: ‘Outside of the US, the floor for inflation is likely to be much higher than what we’re used to, which tends to be quite good for the industrials, the companies focused on activity and trade. This supports Europe and is one of the reasons why Europe is coming back, despite all the pessimism around European growth. This trend is also, to some extent, supportive to Japan, so I think we need to focus on the secular trends and identify the companies that are linked to them.’

Markets at all-time highs – a red flag?

Duncan Lamont: ‘It feels uncomfortable to invest with the S&P 500 hitting all-time highs. Intuition says returns are higher when the markets are cheaper, but it’s wrong, based on my analysis of the historical data. Over the long term the market goes up, which means it is hitting all-time highs on a fairly regular basis. So, whilst it feels hard, you would have done better if you’d invested when the market was high, than if you hadn’t.’

Duncan Lamont: ‘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, it would have destroyed 90% of your wealth (over the entire near 100-year study period going back to 1926). 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%.’

For further listening: Podcast: Life after cash and investing at all time highs

Roberta Barr: ‘All-time highs, as a value investor, it means all-time opportunities given everything else which is going on in a market. Investing in markets in general is obviously a great idea and investing in a balanced and diversified way is an even better idea.’

So a broad approach is best?

Roberta Barr: ‘If you look at the tech bubble, it’s not that the internet didn’t change the world and there weren’t great businesses within that bubble, it’s just they weren’t worth their valuations. No tree can grow to the sky, at some point enough is enough, and calling that point has historically never worked. So, I’m not saying don’t invest in those great companies, more give yourself a bit of value, a bit of something else.’

Remi Olu-Pitan: ‘We do believe that question about a soft landing, non-recessionary rate cuts, potential reflation will support inflation-sensitive assets, so commodities should do well. The point about diversification is key, when markets reach all-time highs, absolutely the approach is to be more diversified, it’s not to move away from investing but widen the opportunity set of investing. A lot of clients do reflect back on the technology bubble, which is why value matters.’

In summary:

Remi Olu-Pitan: ‘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. Whilst equities might seem quite scary given the current levels, just looking outside of the US or under the surface is key, as well as investing in other asset classes, including corporate bonds, commodities, and real assets.‘

Roberta Barr: ‘Sometimes it might feel like cash is the safe, sensible option, but actually it’s value destructive. If you’ve got 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.’

Duncan Lamont: ‘If you’re sitting in cash waiting for the perfect time to invest you could be waiting forever. It will always feel uncomfortable. Any knee-jerk reaction to go all in or all out of the market is risky, to think you can call those tops and bottoms. A more systematic way of investing is going to lead to better long-term returns over time.‘

For a description of bolded terms, please see below

Corporate bonds: bonds issued by companies in the credit market.  Typically riskier than government bonds, they usually offer higher yields to compensate investors for the risk of lending to companies.

Credit spreads: the margin that a company issuing a corporate bond has to pay an investor in excess of yields on government bonds, which is a measure of how risky the market perceives the company to be.

Negative real yields: describes an investment environment where government bond yields are below the rate of inflation, which was a feature of many developed bond markets in the post Global Financial Crisis years.

Magnificent Seven: seven largest companies in the MSCI All Country World Index by free float (publicly traded) market capitalisation, all of which are US technology companies.

Equal-weighted: a stock market index whose constituents all have equal significance, as opposed to capitalisation-weighted indices, where the largest companies have more significance.

Cyclical troughs: companies can be categorised as being “cyclical” if their end markets are sensitive to fluctuations in the economic cycle.

Reflation: used to describe a macro-economic environment where fiscal (government) or monetary (central bank) policies are stimulating economic activity and inflation, including as a result of interest rates cuts.

Real assets: those assets which are backed by physical property (such as commodities, or property) and whose characteristics typically provide investors some protection against inflation.

*Total return of S&P 500 between close on Friday 29 September 2023 and 20 March 2024, LSEG Datastream, Schroders.