After 75 basis points have been shaved off US interest rates , we now find ourselves anticipating the next rate cut. In other news, China will also begin to reduce its policy rate as part of its efforts to stimulate its economy. The cycle of rate cuts introduces a new economic environment, not just for countries initiating the rate slashes but also for those whose interest rate regimes are pegged to these countries. For example, Singapore's fixed deposit rates and T-bill returns are showing signs of decline ever since the Fed commenced the "cutting spree" to revitalise the US economy. In particular, Singapore's 6-month T-bill return hit a 2-year low in recent months.
In light of such evolving conditions, it is important that we remain aware of how to capitalise on an economic environment of declining interest rates. Let us first go over some relevant trends that define the current economic climate.
Lower Fixed Income Returns
Gone are the days where we could enjoy a 5% risk-free rate by simply investing in US treasuries. As interest rates get lower, returns on fixed income instruments like time deposits, treasuries and even corporate bonds start to decline. Mutual funds which are heavily invested in such instruments are also experiencing subpar returns. Such investments were previously one of the best hedges when rates were being hiked incessantly, but they now take the backseat as rates drop.
Higher Equity Valuations
Company valuations often see a sustained rise in an environment of rate cuts. Fundamentally, cash flows are discounted at a lower rate, leading to higher intrinsic values for most companies. In addition, companies holding floating-rate-debt also enjoy significantly lower interest expenses, which is a huge positive impact on their bottom lines. All in all, reduced interest rates generally lead to appreciation of equity valuations. Investments in soundly selected stocks, equity-centric funds, and even private equity funds often trend upwards in such environments.
Increased Consumption of Goods and Services
In such environments, consumers taking floating-rate loans tend to do better financially due to reduced interest payments. This frees up more disposable income for them to spend on various goods and services, which ultimately contributes to higher revenues for many companies. In particular, companies selling goods with higher income elasticities of demand tend to benefit more, as the demand for such products increases more than proportionately as income increases. An example would be companies in the business of high-end tech products like Apple (NASDAQ: AAPL ), or those in the business of luxury accessories like LVMH Moet Hennessy Louis Vuitton SE (EPA: LVMH ).
In light of the above, here are a few recommendations one may consider.
1. A Rotation into Risk
A general consensus in such economic conditions would be to rotate a portion of capital invested in fixed income instruments into equity-focused ones. For example, one may consider reducing his or her holdings of TLT ETF or perhaps a US treasury bond, and increasing holdings of an index fund like SPY ETF, or even certain blue chip company stocks. Such recommendations, which are often given by financial consultants or investment professionals, are consistent with the assumption that fixed income instruments tend to do worse, and equities tend to do better in an environment of rate cuts. As such, doing so can position your portfolio to earn better returns.
2. Potential Option Strategies
In a generally bullish environment for equities, income-generating option strategies like the selling of puts or bull spreads become significantly more attractive. Buying calls strategically are also more favourable in such environments. With equity prices appreciating, these option strategies become easier to implement and provide another avenue of profit for investors.
3. Trading The Technicals
With increasing amount of capital being injected into stock markets, one may consider trading on technical indicators like moving average convergence/divergence (MACD), relative strength index (RSI), stochastic oscillators and many more. An improvement in market sentiment often presents multiple trading opportunities as trading activity increases significantly. One can look towards incoming earnings calls and FOMC meetings, amongst other things, to further magnify trading gains.
All in all, there are multiple ways to profit in an environment of rate cuts. That being said, one should always do the necessary due diligence before determining if the above recommendations are relevant to his or her portfolio.