“Interest rates are falling - what to do with the money?”

Interest rates are falling, bring on the long-term investors!

One of the peculiarities of recent years has been that long-term interest rates have been lower than short-term rates. In technical terms, this means that the yield curve was inverted. Opinions differ as to why this was the case. What is certain, however, is that short-term bonds allowed investors to reduce their maturity risk and optimize their returns at the same time. Even after deducting inflation, it was possible to earn decent real returns with money market-oriented funds. This period is now coming to an end. Short-term interest rates will fall, which should support the prices of longer-term securities.

It is unclear how strong this effect will be, but because the US economy does not appear to have suffered any lasting damage during the high-interest phase and the pace of economic growth is only slowing, long-dated bonds will benefit but are unlikely to ignite a price turbo. What is certain, however, is that the opportunity costs for investments in short-dated bonds will rise. This means that investors will rely less on overnight money and money market funds and invest more in risky securities.

This trade has a maturity date. At some point, when the lower interest rates have caused the economy to heat up, the cycle will turn again and the central banks will tighten the interest rate screw again. But that is a long way off. At present, there is good reason to hope that investors in longer-dated bonds can enjoy sliding down the yield curve. According to the current logic, those who buy long-dated bonds are likely to make substantial price gains. And because it cannot be ruled out that the economy will not cool down after all, bond investors have the option of making generous recession profits. 

The growth sparrow on the roof becomes more attractive

When interest rates fall, future cash flows become more attractive compared to current cash flows because the discount factor for cash flows falls. This means that companies that invest and increase their sales in a targeted manner will become more attractive to investors again. Today, companies with strong cash flows have an advantage. This will change:  Growth stocks, second-line stocks and also technology stocks from the second and third tiers will benefit disproportionately from falling interest rates.

However, things are getting a little foggy at this point. Tech stocks corrected in the third quarter, and second-tier companies have also underperformed in the past two months. If it is only a matter of cash flow logic, then they should have outperformed. There are several possible explanations for this: firstly, many investors are not ruling out the possibility of a recession after all. They are playing it safe. This explains why cash flow machines such as utilities are currently making particularly strong gains.

Another uncertainty factor concerns the beneficiaries of the AI revolution. We are currently seeing a sharp dip in the share prices of companies such as NVIDIA, ASML, AMD, TSMC, Broadcom, Lam Research and others. It was only a matter of time before investors would deflate after many shares had doubled in price. However, there is no guarantee that the hype will turn into a crash, along the lines of the tech bubble from 2000 onwards. Today's AI winners are generating real sales and have solid business models. A sell-off of the Magnificent 7 seems obvious, but as things stand today, it is probably overdone. Perhaps a reduction in the weight of the Nasdaq 100 ETF could be justified, but not a sell-off? Portfolio rebalancing should not be a top or bottom issue. So investors don't need to weigh whether to replace traditional value sectors, such as energy, financials and especially utilities, in favor of smaller technology stocks. Why not combine both styles in your portfolio in the form of suitable funds or ETFs? 

Where to put the money? Curtain up for the carry trade

When it comes to the question: “Where to put the money?”, the carry trade is a must in the current situation. The strategy is part of the standard repertoire of many investors. Even those who are unfamiliar with the term implement the carry trade. In the literal sense, “carry” implies that investors “carry” their money from a low(er) yielding form of investment to a higher yielding one. In technical terms, a carry trade is an investment from a currency area with low interest rates to a currency area with higher interest rates using borrowed capital. The logic behind the use of leverage is compelling at first glance: the greater the difference between the interest rates for loans on the home market and the investment interest rates on the target market, the more worthwhile it is to take out a large loan. However, if the parameters change, distortions can occur. If interest rates on the source market rise, for example, there is a risk of high losses on leveraged investments. It was only in August of this year that there were massive distortions as a result of the unwinding of carry trades. The massive unwinding of yen loans as a result of the Bank of Japan's interest rate hike, for example, sent share prices around the world into turmoil.

But this is not about the risks for gamblers, but about the investment strategies that are also open to ordinary investors. With falling interest rates in the USA and Europe, high-yield markets are becoming attractive. More and more investors are therefore likely to invest in emerging market bonds in the coming months. Over the past three years, investors worldwide have withdrawn money from these funds. If the direction of fund flows reverses, a positive momentum effect can be expected for emerging market bonds.

The carry trade could be doubly worthwhile for investors from the USA and Europe: On the one hand, investors will have the prospect of sufficient interest rate differential trades. At the same time, the stronger capital flows towards emerging markets will strengthen the local currencies of these countries. Interest rate gains will therefore be accompanied by currency gains. Emerging markets bond funds denominated in local currencies will be the beneficiaries of the new interest rate regime of the ECB and the Fed. Investors can participate in this via funds and ETFs.

From Ali Masarwah, 23 September 2024, © envestor.de

Ali Masarwah is a fund analyst and managing director of envestor.de, one of the few fund platforms that pays cashbacks on fund sales fees. Masarwah has been analyzing markets, funds and ETFs for over 20 years, most recently as an analyst at the research house Morningstar. His expertise is also valued by numerous financial media in German-speaking countries.

This article reflects the opinion of the author and not that of the editorial team of boerse-frankfurt.de. Its content is the sole responsibility of the author.