At the start of August, the Bank of England announced a long-awaited interest rate cut. At just 0.25%, the absolute level of the cut may be small, but it sets the direction of travel for financial markets over the next year. It also has a number of implications for the Shires portfolio.

Interest rate cuts may imply good or bad news on the UK economy. They may fall because the Bank of England is worried about growth and feels the need to stimulate business and investment to avoid a recession. On the other hand, it may be that interest rates had risen to try and counter inflation and, with inflation under control, can now move to a more normal level.

It is this latter scenario that is in play today. Interest rate cuts are being made from a position of relative strength, with the UK’s economic data increasingly robust. The UK economy increased by 0.6% from April to June, following an increase of 0.7% in the first quarter. This puts it ahead of much of Europe, and edging closer to the US.

This is good news for UK companies, which are operating in a more benign environment. It should benefit smaller companies in particular, which tend to have more exposure to the UK domestic economy. Historically, small and mid cap companies have delivered higher returns than larger companies in the aftermath of a rate cut, and this looks even more likely today given the recent weakness in this part of the market.

Cash versus shares

The immediate impact of a rate cut is that people earn less interest on their cash savings. The major banks have already moved to cut rates for savers and are likely to cut further if, as expected, the Bank of England comes through with more rate cuts later in the year. This changes the relative appeal of cash over the stock market, and equity income funds like Shires in particular.

For equity income funds, higher savings rates tend to be a disincentive. If people can earn 5% in the bank, they often don’t see the need to take equity risk. However, as cash rates are cut, they look to other sources of income and trusts such as Shires, with a 6.0% yield, have more appeal. It is also worth noting that much of the equity income sector still trades on a discount to its net asset value, which enhances the yield.

As long as they are happening for the ‘right’ reasons, interest rate cuts tend to improve sentiment in stock markets. This is particularly important for the UK market, which has battled poor sentiment for much of the past decade. Sentiment had already started to improve even before the rate cut. Increased political stability has helped, as has improving economic data. The most recent Bank of America Fund Manager survey showed more international investors likely to buy UK stocks over the next 12 months. Until July, the UK had languished near the bottom of the closely watched survey.

The impact of rate cuts

Interest rate cuts also have implications for individual companies. Over the past year, we have been boosting our position in small and mid cap companies, where we find more value and more yield. Interest rate cuts should support this positioning.

Equally, the fixed income share of the portfolio should be a clear beneficiary of lower rates. We hold a basket of preference shares, just under 20% of the portfolio today. These trade more like bonds than equities. Bond markets are beneficiaries of falling rates – higher rates push yields lower and prices higher. Stocks that have bond like qualities, such as utilities, also tend to benefit from lower rates. This is around 8% of the Shires portfolio today.

Financials are our largest sector weighting and major banks such as NatWest feature among our largest holdings. Investors might expect banks to be vulnerable to rate cuts. Certainly, high interest rates are supportive of bank earnings. However, the UK banks are a little different because of the way they hedge interest rate risk. They hedge a portion of their exposure to interest rates three to five years forward, so are still rolling off hedges put in place when interest rates were very low, resulting in an uplift to profitability even as rates come back down. We believe their earnings should continue to rise over the next two to three years as a result.

Uncertainty and priorities

There are still risks. The incoming government will lay out its tax and spending plans in more detail at the end of October. There is push and pull between its business-friendly rhetoric and the need to find new sources of revenue. Rumours of a rise in capital gains tax have already created some selling pressure, particularly in parts of the market that have done well.

Equally, the volatility seen at the start of August showed that markets are still vulnerable to any slightly bearish economic data from the US. Federal Reserve decisions on interest rates, plus the upcoming presidential election, have the potential to destabilise global equity markets. Against this backdrop, resilience and defensiveness still matter. We continue to prioritise the protection of income and capital.

Lower rates are a positive development. They support stock market investment over cash, and equity income strategies in particular. They help sentiment towards the UK after a long period when it has been out of favour. They also help specific parts of the market, including smaller companies and fixed income holdings. However, they are not a complete defence against volatility, so we maintain some defensiveness in the Shires portfolio.

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Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London, EC2M 4AG, authorised and regulated by the Financial Conduct Authority in the UK.

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