By Gilbert Abela
Although prices remain high, the pace at which they’ve been climbing is starting to cool off. The inflation rate is a crucial monetary phenomenon because it directly affects how much our money can buy. Central banks typically aim to keep inflation around 2% annually, encouraging spending by increasing tomorrow’s prices slightly but not enough to destabilise the economy. Central banks manage the inflation rate through their main monetary policy tool, interest rates. Increasing interest rates reduces investment and expenditure appetite as borrowing becomes more costly. Conversely, lowering rates has the opposite effect and stimulates the economy.
The global economy is transitioning from a high inflation and high-interest rate environment to a more normal inflationary environment allowing for lower interest rates. This shift often carries the risk of a recession, as elevated interest rates can slow down economic activity. Economic data tends to look backwards, so central banks must be proactive rather than reactive. However, with more real-time data available, central banks can respond more quickly than in the past. Additionally, it’s essential to recognise that the effects of lowering interest rates take time to materialise. Considering this, central banks are carefully seeking to optimise the interest rate reduction timing, aiming to control inflation while avoiding a significant economic slowdown—a scenario often referred to as a "soft landing."
In a declining interest rate environment, certain stock market sectors are likely to outperform others. Real Estate and Utilities, both heavily leveraged, are expected to see improved profitability, making them appealing to investors seeking stability and income. European forward electricity prices suggest a decrease in electricity prices for the next year, which could potentially hinder the profit growth of utility companies. However, this trend should support the broader European economy as it translates to lower utility bills for households and corporations. Lower borrowing costs are expected to lead to increased investment and consumer spending, which will benefit the Consumer Discretionary, Information Technology, and Industrial sectors. These sectors tend to grow faster than the economy during expansionary periods.
Health Care, Consumer Staples, Materials, and Communication Services may see mixed outcomes. While these sectors can remain stable due to their defensive nature, broader economic conditions often influence their performance. The demand for Healthcare and Consumer Staples products is typically stable resulting in stockier demand and predictable revenues and returns. At the same time, Materials and Communication Services are more vulnerable to fluctuations in commodity prices and shifts in economic sentiment. Avoiding a recession is crucial for the Materials and Communications sectors to do well, as lower revenues from a demand slowdown will far outweigh the benefits of lower interest rates.
However, not all sectors fare equally well. Sectors such as Financials and Energy generally face challenges in a low-interest-rate environment. Financials encounter compressed profit margins as the gap between borrowing and lending rates narrows, reducing their earnings potential. This doesn’t mean that all banks should be viewed negatively, as a few manage to structure their balance sheet to limit the effect of declining interest rates. The Energy sector, which relies heavily on global demand and oil prices, may suffer if declining rates signal weaker economic growth. However, A soft-landing scenario should not be catastrophic for these sectors as the economy keeps humming. A healthy economy supports energy prices and loan defaults should remain relatively low.
In summary, while sectors with high debt levels or strong growth prospects often thrive when interest rates fall, financial and energy companies may encounter challenges. Lower borrowing costs increase consumers' disposable income and investment benefiting the Consumer Discretionary, Information Technology, and Industrial sectors. This presents an opportunity for active fund managers to outperform by increasing allocations to sectors expected to benefit most from a low-interest rate environment.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.