Trading in a low-rate environment: what are the risks and opportunities?

On the day before Halloween, the US Federal Reserve’s decision to lower the benchmark federal funds rate by a quarter percentage point to a range of 1.5-1.75% provided a treat for stock market traders.

 

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The Fed carried out its third interest rate cut in four months to counteract weaker business investment resulting from the US-China trade dispute, which has slowed US economic growth. The S&P 500 showed a strong stock market reaction, responding positively to the move to close up 0.3% on the day at a record high of $3046.77.

Low-interest rates in advanced economies have been a regular feature of the global economic and investment environment since the 2008 financial crisis. 

In the UK, interest rates sit at 0.75%, with expectations that they could return to record lows of 0.25% in the event of a messy Brexit.

  

The next Bank of England policy meeting, which will be in early November, will be keenly followed by analysts and stock market investors.

Russ Mould, investment director at AJ Bell, told Proactive Investor that many of those at the Bank of England, including governor Mark Carney, have indicated for a while that there is a desire to further increase interest rates amid a low employment environment, while wage growth also overtakes inflation

However, members of the Monetary Policy Committee have also been using this Brexit-related uncertainty as a reason for not increasing the headline cost of borrowing. 

“Throw in interest rate cuts from central banks in Europe and America, to name but two, and it’s pretty hard to see the Bank of England raising rates and a lot easier to see it shifting stance toward making a case for cuts,” Mould says.

The European Central Bank’s main deposit rate is at a negative 0.5%, which means it charges banks to deposit their spare cash with the Frankfurt-based central bank. This makes it harder for banks to lend to businesses and individuals. To help offset the costs to banks from the ECB’s negative deposit rate, it introduced a system that exempts a portion of a bank’s deposits from the charge, but it’s not yet clear how much that system will end up helping European banks.

“Throw in interest rate cuts from central banks in Europe and America, to name but two, and it’s pretty hard to see the Bank of England raising rates and a lot easier to see it shifting stance toward making a case for cuts” - AJ Bell investment director Russ Mould

 

The push into riskier assets

Savings accounts are the first main casualty of low-interest rates. Investors tend to move away from cash as saving accounts that pay interest below the rate of inflation mean value gets eroded. Investors also tend to switch out of safe government bonds as low and negative interest rates – along with central banks’ bond-buying initiatives – depress bond yields.  As a result, investors look to riskier assets, such as equities and high-yielding bonds, to generate returns.

As lending is incentivised in a low rates environment, corporate profits increase and in turn stocks and asset prices climb up, DayTrading.com explains. This creates opportunities for traders looking for opportunities in stocks. Low rates also lead to “cheap and abundant leverage”, which can encourage excessive speculation on some particular assets, in turn increasing the risk of bubbles forming in a certain sector or sectors – bad news for an economy as stocks become over-inflated, but good news for short sellers. 

The FTSE 100 offers investors plenty of opportunities, said Harry Merrison, an investment manager at Kingswood.  “A further 0.25% reduction in US interest rates was accompanied by a more cautious tone. US markets have been buoyed by the optimism and again look frothy,” he told Opto. 

“In the UK, we have had a decade of ‘lower-for-longer’ interest rates and, latterly, unprecedented political risk. In all likelihood, the UK equity markets, which are cheap in relative terms, will continue to remain attractive for investors until such political risk has subsided.”

“In the UK, we have had a decade of ‘lower-for-longer’ interest rates and, latterly, unprecedented political risk. In all likelihood, the UK equity markets, which are cheap in relative terms, will continue to remain attractive for investors until such political risk has subsided” - Kingswood investment manager Harry Merrison

 

Given that the FTSE 100 is currently yielding a “hearty” 4.5%, which is significantly above the 0.69% 10-year gilt yield and 0.75% base rate, why would any rational investor opt for capital erosion by inflation, Merrison asked. 

“Notwithstanding the fact that over 70% of FTSE 100 constituents derive the majority of their revenues from offshore, meaning that the current sterling weakness is positive for their bottom lines,” he explains, “in the era of ultra-loose monetary policy, ’there is no option’ contrarian investors should seek out cash-generative, high-yielding stocks and hold on tight.” 

 

Surveying the investment landscape

Some sectors to explore would be housebuilders, as lower mortgage rates encourage both buyers and sellers, as well as those that are historically big dividend payers, like utilities. Low rates also help borrowing and capital investment, so infrastructure-related firms could get a boost to their project plans.  As such, holdings in real estate assets could be explored more thoroughly by investors.

However, investors should exercise caution when it comes to picking individual stocks. The low-rate environment makes debt cheaper to service, which can lead to an increase in so-called zombie companies. These are companies that are struggling with debt and cash flow and, in a more normal interest rate environment, would likely collapse because of their inability to pay back loans. 

It’s also important to be wary of companies with large pension deficits, as low-interest rates tend to increase their liabilities. In addition, banking stocks could prove to be a challenging investment choice, because their net interest margins tend to come under pressure from low rates.

In terms of looking at other bonds that offer high yields, investors could consider corporate bonds, mortgage-backed securities and emerging market debt. But many of those come with fairly risky profiles that should be analysed closely before committing to a position.

 

All that glitters

When looking at the range of assets in the low-rate environment, the lure of gold can become more potent, according to Thomas Carr of the Motley Fool.

“Low-interest rates make gold more attractive to investors. It is a non-interest-bearing asset, so when rates are higher, investors tend to move out of gold and into areas where they can earn higher returns,” he said. “But in the current environment, gold has been one of the best-performing assets of the year, up 26% in 12 months. The yellow metal is seen as a safe haven in times of uncertainty.”

“But in the current environment, gold has been one of the best-performing assets of the year, up 26% in 12 months. The yellow metal is seen as a safe haven in times of uncertainty” - Motley Fool's Thomas Carr

 

Other ways investors can take advantage of the gold trade is by buying shares in gold mining companies, such as Barrick Gold, which is up by nearly 25% so far this year, or exchange-traded funds that track the gold price.

Beyond the key rule of portfolio diversification, other measures of risk and reward also remain relevant. For example, avoid taking risks that wouldn’t be taken in an environment where interest rates are at 5% or 6%.