Market Musings 161223: Winners from Lower Rates

Market Musings 161223: Winners from Lower Rates

Some relief for borrowers, at last

Summary

• Long term interest rates fall hard

• Who benefits from lower interest rates? Real Estate, Housebuilders

• Utilities too

Podcast this week:

Outlook 2024: Why we stay positive on Stocks and Corporate Credit

In this podcast, Edmund Shing, Global Chief Investment Officer of BNP Paribas Wealth Management gives his outlook for 2024.

• How far can inflation fall?

• Lock in attractive bond and credit yields

• Identify attractive regional stock markets

• Are illiquid assets a good card to play?

Long term interest rates fall hard

Since peaking in mid-October in the US and France, and in mid-August in the UK, long-term interest rates in the form of 10-year government bond yields (the fixed rate investors receive for lending money to the government for 10 years) has fallen from peak by 1%, to 4% in the US, to 3.7% in the UK and to 2.6% in France.

Long-term interest rates (10-year government bond yields) fall 1%

Source: tradingview.com

This drop represents a sharp reversal of the upwards march in long-term interest rates in place since late 2021, when the UK 10-year gilt (government bond) yield rose from 0.7% to as high as 4.75% at peak.

Long-term interest rates are following, in a lagged fashion, the path of inflation which rose to peak at the end of 2022, and which has since fallen sharply to 2.4% in the Eurozone as of November.

Eurozone inflation drops from over 9% to 2.4% in November

Source: tradingeconomics.com

It seems likely that inflation rates will continue to ease lower in Europe, the UK and the US in the months ahead, judging by the underlying disinflationary trends in key inflation components such as rents, Chinese export goods prices, energy prices and even food prices.

With inflation rates now approaching the official 2% target of major central banks, interest rate markets have now begun to anticipate interest rate cuts from early 2024 by the US Federal Reserve, the European Central Bank, and the Bank of England.

This anticipation of lower central bank reference interest rates in the months ahead has sent 2-year government bond yields sharply lower, with the 2-year UK gilt yield falling from 5.5% at peak to 4.3% on Friday.

UK 2-year gilt yield has dropped 1.2% to 4.3% now

Source: tradingeconomics.com

There has been a similar fall in the cost of borrowing for high quality European companies, in the form of a falling Eurozone investment grade corporate bond yield (from 4.6% at recent peak to 3.7% now).

Eurozone investment grade corporate bond yield falls to 3.7%

Source: S&P Dow Jones Indices

Who benefits from lower interest rates?

In general, lower interest rates are a benefit to borrowers (who pay interest costs), but bad for savers (who receive interest income).

Falling 2-year gilt yields are leading to lower 2-year fixed mortgage rates in the UK, now below 6% for the first time in almost 6 months.Prospective borrowers with larger cash deposits (and who are thus better risks from the perspective of a bank) can borrow at far lower rates than this - the Nationwide, for example, is offering movers with a 40% deposit a two-year mortgage deal fixed at 4.65%, and a five-year fix at 4.29%

So the first beneficiaries should be sectors and industries that are largely financed with borrowed money, namely Real Estate and Housebuilding.

As expected, both UK commercial property funds (see the IUKP ETF below) and UK housebuilding stocks such as TW. Taylor Wimpey have recovered a lot of lost ground since the end of October.

UK 2-year gilt yield has dropped 1.2% to 4.3% now

Source: tradingview.com

Bear in mind that even after this latest recovery, both UK housebuilders and UK commercial property REITs remain cheaply valued.

TW. Taylor Wimpey still offers a 6.4% dividend yield and holds 15% of its market value in cash on its balance sheet.

BLND British Land still trades at 0.71x Price/Book Value, i.e. a 29% discount to their underlying stated value of their property assets.

Building aggregates suppliers should also benefit from a pick-up in building activity as interest and mortgage rates decline. After all, in the long term there remains a shortage of decent housing stock in the UK.

BREE Breedon Aggregates and MBH Michelmersh Brick Holdings are two smaller companies that have also started to see a share price bounce over the past month or so.

Aggregates suppliers and brickmakers bounce

Source: tradingview.com

Utilities sector is sensitive to long-term interest rates

The Utilities sector, which includes companies involved in power generation and distribution of electricity and gas, is a highly regulated sector with stable revenues which is sensitive to the direction of long-term interest rates, as utilities companies are generally heavily indebted.

Utilities companies SSE and National Grid surge on lower interest rates

Source: tradingview.com

Income seekers may still be attracted to NG. National Grid, as it still offers a 5.6% dividend yield even after its latest share price move.

Conclusion

Lower interest rates have been a strong following wind for stock markets in general since the end of October. The Santa Rally period kicks in now until early January, and could be a further factor in driving stocks higher in the very near term.

Lower inflation and lower long-term interest rates are clearly helping long-suffering sectors such as listed Real Estate, Housebuilders and Utilities companies all recover, in spite of the relatively weak economic growth outlook.

Expect central banks to begin to cut interest rates before mid-2024 on the back of persistently lower inflation rates. Even if stock markets have already rallied hard and look extended in the short term, the next few months could still prove positive for global stock markets, and in particular for interest rate-sensitive sectors and stocks that have lagged up to now.

All the best for the week ahead,

Edmund