Three investment ideas for falling rates

Key takeaways

1. Could history rhyme: the UK stock market saw a dramatic recovery in 1966 following rate cuts
2. Interest rate correlation: there is a strong correlation between falling interest rates and rising stock markets, particularly in sensitive sectors
3. Sector-specific opportunities: certain sectors, such as US small caps, UK mid cap stocks and global listed infrastructure may offer strong return potential following rate cuts.

Lessons from history

In late 1966, the UK stock market was in a mess. By the 8^th November the FT Index had fallen 24% since Labour’s win in the 1964 General Election. Investors were numbed by the misery.

Turnover had all but collapsed – the total value of all equities traded in September came to a mere £180m – and shares were unambiguously cheap (the average yield was nearly 7%).

Then, something changed. The feelgood factor from the England team winning the football world cup seemed to seep into markets. There was a sudden return of M&A activity: BAT bid for Yardley, GE for Telephone Rentals and Leyland for Rover.

There was some improvement in the UK’s relationship with Europe: the decision to apply to join the Common Market came early in the year. Then the Bank of England interest rate was cut. It went from 7% to 6% by March 1967 and then to 5.5% by May.

Something worked: the All Share index soared and, by January 1969, it was up 106%. 

England (or Scotland) might not have won the football, but nonetheless, might history be about to rhyme? Perhaps. Turning to now, there is a strong correlation between falling interest rates and rising stock markets – particularly in a few sensitive sectors. Look to the US and you can see the trend: on average, since 1928, US equities have returned 11% after inflation in the 12 months after a rate cutting cycle begins¹.

That’s even the case if rates are cut into a recessionary environment: data from Schroders suggests that in times of recession, the performance over inflation has been 8% (with a few nasty exceptions of course), without one it has been 17%.

Fidelity have looked at it since 1954 and found similar numbers albeit with stocks doing even better in the 12 months after a recession rate cut than otherwise (13.9% vs 12.6%).  The UK data shows similar trends². 

A closer look at US small caps

But there’s an extra element to this. If you are looking to benefit from rate cuts, there’s a chance to get returns that don’t just track markets - but that do rather better. Anyone in any doubt on that might take a look at what happened on 11^th July. Then, a set of low inflation numbers plus a hint from the US Federal Reserve (‘Fed’) that cuts are finally on the way, affected some parts of the US equity market rather more than others.

Growth stocks, and particularly the big technology stocks, floundered a little, but US small caps? The Russell 2000 shot up 3.6% in a day. Why the divergence? It’s partly because small caps tend to rely more on short term and variable debt (and more on debt over all), so a cut in interest rates affects them more than it does bigger companies.

Look to market history again and you can see this in action: since 1970, US small caps have outperformed large caps 76% of the time in the first 12 months after rates started to fall and earnings to rise³.

This time round, however, there is an extra kicker: relative to large cap stocks, US small caps are very cheap. As of July, the 50 largest stocks in the US Russell 3000 index (a broad index that covers the 3000 largest stocks in the US) were trading at a 30% premium to the bottom 450 and the weighting of small caps in the Russell 3000 is near a 20-year low.

Small caps, and value small caps in particular, are also pretty much the only part of the U.S. market trading below long term averages and near their lowest valuation relative to large caps in 25 years. 

If rates are set to fall in the US and the UK what do you want to own? Something expensive that could benefit a bit, or something already historically cheap that could benefit a lot? Quite. 

From 1955 to 2023, according to the Deutsche Numis Mid Cap Index, UK mid caps have returned 7.8% per year in real terms. Yet today, they trade at a near 20% discount to their historical average valuations. They may love rate cuts as much as US small caps. One to watch.

Is it time to look at listed global infrastructure?

A third sector to keep an eye on is listed global infrastructure. This has had a delightful record of outperformance over every period from six months to five years after the last Fed rate hike. Five years out, on numbers from ClearBridge, global listed infrastructure funds have on average returned 90% against 52% for global equities as a whole⁴.

Source: ClearBridge internal research, May 2024. MSCI. Past performance is no guarantee of future results. Returns are in local currency.

As high rates weighed the sector down and investors fled to the apparent attractions of the giant tech companies, global infrastructure stocks are also now very cheap in relative terms: in 2023 global listed infrastructure underperformed global equities by 22 percentage points⁴. In relative terms, the sector is now as cheap as it was post pandemic, despite greatly improved business fundamentals. 

In his book, ‘The Stockmarket’, John Littlewood, stock market historian, compares a bull market to a river. Its first phase happens against the better judgement of majority opinion. An early trickle expands slowly, gradually becoming a river before swelling to a torrent of flood water in the full spate of a bull market.

The skillful enjoy the whole ride. The majority just the rapids at the end. If rates really are to fall and history to repeat itself, all these three sectors might be just entering their trickle stage. 

•  FT Index: This index tracks the performance of the UK stock market. It fell 24% after Labour's win in the 1964 General Election but saw a dramatic recovery in 1966 following rate cuts1.
• FTSE All Share Index: Represents the performance of all shares listed on the UK's stock exchange.
• Russell 2000: An index that measures the performance of approximately 2000 small-cap companies in the US.
• Russell 3000: Covers the 3000 largest stocks in the US, providing a comprehensive look at the American stock market.
• FTSE 250: Tracks the performance of 250 mid-cap companies listed on the UK's stock exchange.
• Deutsche Numis Mid Cap Index: Measures the performance of UK mid-cap stocks.
• RARE 200: An index that measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.