Interest rates should be coming down across the world – even in places such as the UK, where inflation ticked higher in the UK in April. At least that seems to be the broad consensus.
There are two main reasons for this in my mind. First, despite a spike in price rises in April, inflation is much closer to central banks’ target 2% than it has been for the past two years. Second, economic growth is slowing (and could be under severe pressure following US president Donald Trump’s tariff tirade).
It was someone far more experienced and knowledgeable than I who alerted investors to the problem this week, when veteran bond manager Richard Woolnough warned the pace of interest rate cuts could come as a surprise in 2025.
But investors looking to see what should work in this environment might want to pause before jumping to conclusions.
Earlier this week, Helen Xiong, FE fundinfo Alpha Manager of the Monks Investment Trust, told Trustnet that the way economics is taught in schools and university is redundant.
Students are taught ‘Centrus Paribus’ – the Latin term for holding all things equal. “It is an admission that we cannot understand the outcomes of the world as it is, so we have to simplify and only move one variable and assume nothing else changes. That is unrealistic, but almost all economic theories are based on that,” she said.
She pointed to the post-financial-crisis period during the 2010s, when huge quantitative easing efforts from central banks should have led to inflation, but did not.
I believe investing solely based on the direction of interest rates is folly, but let’s play along.
If rates fall, growth stocks should get a boost as the discount rate reduces. Essentially, the earnings of companies, such as tech stocks, are forecast far into the future, with their share price reflective of this expected future growth.
When interest rates are lower, shares should rise. After all, investors who were happy to pay up for potential future earnings when they could get good returns from bank accounts and bonds should be even more likely to pay up for it when the yields on offer are lower…right?
Then there is gold, which should thrive in a lower interest-rate world. The yellow metal should underperform when rates are higher as cautious investors looking to park their cash away can invest in low-risk government bonds and claim an almost-guaranteed return, while gold is a speculative investment that relies on the price increasing.
But it is not that simple. Both assets have been on a tear in recent years during eras of higher rates – precisely the time they should have struggled, according to economic theory. The former has jumped thanks to the rise in artificial intelligence (AI) and the latter has been a safe haven against war and uncertainty, two things that have dogged markets recently.
Gold has also benefited from central banks buying the precious metal as a hedge against the dollar, which is increasingly being viewed as less stable and less worthy of its role as the world’s reserve currency.
It is hard to believe that lower interest rates will send both of these assets – which have reached stratospheric heights over the past few years – to rocket once again.
While it is possible, as Xiong stated, this implies that only one factor changes. In truth, there are myriad moving parts that will come into play.
For now, the world is too uncertain to make binary bets on one economic policy or another. Investors should instead either diversify through investing in a broad basket of stocks, or pick fund managers who are better equipped to look at multiple probabilities and invest accordingly.
At least that’s what I will be doing with my savings.