Cooling Inflation: Rate Cuts and the Reshaping of Global Markets

As inflation cools globally, central banks worldwide are preparing to shift gears from aggressive interest rate hikes to potential cuts, signalling a significant shift in the global economic landscape. This marks the end of an era dominated by elevated interest rates and persistent inflation concerns, ushering in a new investment environment that could dramatically alter returns across different asset classes.

Since 2022, interest rates and inflation have been at the forefront of economic discussions as central banks around the globe took steps to combat surging prices. This departure from the decade-long era of zero interest rate policies saw the US Federal Reserve spearhead a series of rate hikes totalling 525 basis points, bringing the federal funds rate to a range of 5.25% to 5.50% – levels not seen since 2001.

Interest rates wield considerable influence over financial markets and the broader economy. They dictate borrowing costs for both consumers and businesses, and when high, they tend to stifle consumer spending and business investment. High rates also make fixed-income assets like corporate and treasury bonds more appealing compared to riskier investments such as stocks.

Disinflation, Rate Cut Expectations, and Asset Class Performance

As we progress through 2024, there are clear signs that inflation is cooling across the globe. In the US, the Consumer Price Index (CPI) has dropped considerably from its peak of 9.1% in June 2022 to 2.9% in July 2024. Similar trends are evident in other major economies, with the Eurozone experiencing inflation falling to 2.6% in the last month, down from a peak of 10.6% in October 2022.

Even emerging and frontier markets are experiencing disinflation, signifying that prices are still rising but at a slower pace. India's retail inflation eased to 3.5% in July from 5.1% in January, and several African economies, including South Africa, Ghana, Ivory Coast, and Nigeria, reported slowing inflation rates.

This cooling inflation has ignited expectations of interest rate cuts, with markets anticipating the US Federal Reserve (Fed) to begin easing monetary policy as early as September. Some central banks in emerging markets have already initiated this process, with countries like Zambia maintaining rates after previous hikes, while others like Botswana, Rwanda, and Namibia have implemented modest cuts.

The stock market has responded positively to these developments, with major indices trending upwards fueled by encouraging inflation data and robust employment reports. Financial institutions and market analysts are increasingly confident that the Fed will execute at least a 25 basis point rate cut next month, a move that could significantly impact various asset classes and sectors.

The Potential Impact of Rate Cuts on Asset Classes

Historically, stocks have tended to perform well in the early stages of rate-cutting cycles, particularly if the economy avoids a recession. Lower interest rates can boost corporate profits by reducing borrowing costs and potentially stimulating economic growth.

Sectors particularly sensitive to interest rates, such as real estate, utilities, telecommunications, and consumer discretionary, could see outsized benefits. Growth stocks, which derive more value from future earnings expectations, could also outperform as lower rates enhance the present value of future cash flows.

Bond prices and interest rates share an inverse relationship. When interest rates rise, bond prices fall, and vice versa. In 2022, rising interest rates caused bond prices to drop significantly. Recently, bond prices have been increasing due to concerns about an economic slowdown and expectations that central banks will lower interest rates to support the economy.

With inflation now closer to target levels, central banks have greater flexibility to reduce rates without worrying about reigniting inflation. This situation could create favourable conditions for investing in government bonds, considered safe-haven assets. Investment-grade corporate bonds may also benefit from both falling rates and potential spread compression as economic conditions improve.

Gold, often a strong performer in environments of falling interest rates as investors flee a weakening US dollar, is already gaining popularity, especially among central banks seeking to reduce their reliance on the greenback. With US interest rates expected to decline, gold prices could rise further. This is positive news for gold mining companies as they become more profitable when gold prices increase.

Charteris, a wealth management firm, predicts gold could reach over $3,000 per ounce in the next 4-10 months, up from around all-time highs of $2,500 now, driven by factors such as increasing global debt or geopolitical tensions that could push prices higher even faster. This positive outlook for gold highlights its appeal as a safe investment during uncertain economic times, potentially attracting more investors seeking stability and growth opportunities. Other precious metals may follow a similar pattern. For broader commodities, the impact of rate cuts is less straightforward, as it depends on the balance between economic stimulation and currency effects.

Investors May Turn to Emerging and Frontier Markets for High Yields

As rates in developed markets decline, investors may increasingly turn towards emerging and frontier markets, particularly in Africa, in search of higher yields. Countries with improving economic fundamentals, such as Nigeria with its rising oil output and growing foreign exchange reserves, Gabon whose high oil production is offsetting political uncertainties, or Kenya with its diversified economy, could attract significant capital flows.

These countries have seen widening spreads over US Treasuries, suggesting potential opportunities for yield-seeking investors. A Bloomberg report reveals that these nations' dollar-denominated sovereign bonds have generally underperformed compared to their emerging and frontier market counterparts.

However, the past week has witnessed a notable turnaround, with bonds from these African nations outperforming in the context of a broader risk rally. This improved performance coincides with growing expectations that the Federal Reserve may adopt a more accommodative monetary policy stance soon.

This recent outperformance may indicate that investors are beginning to recognize the value proposition offered by these higher-yielding African sovereigns, especially in an environment where developed market yields are expected to decline.

As the global interest rate landscape evolves, these bonds – including those of countries like Ivory Coast, Benin, and Senegal – could continue to attract attention from investors seeking attractive risk-adjusted returns.

Bottom Line: Investment Strategies and Market Outlook

As the investment landscape evolves, investors should consider adapting their strategies to capitalise on the changing environment. Diversification remains crucial, with allocations spread across asset classes and geographies to capture potential opportunities while managing risk.

In fixed income, extending duration could prove beneficial as rates fall, while equity investors might focus on high-quality companies with strong balance sheets, such as large telecom operators like MTN Group, Orange, and Sonatel, which can weather potential economic uncertainties.

The potential for rate cuts is likely to stimulate consumer spending by making financing for large purchases more affordable. This could boost sectors related to consumer discretionary goods and housing. Also, lower interest rates can improve corporate balance sheets by reducing debt costs, potentially freeing up capital for investment, research and development, or stock buybacks. These factors often make companies more attractive to investors, further supporting stock prices.

It's worth noting that while the stock market often responds quickly to changes in interest rate expectations, the broader economic impact of rate cuts typically takes several months to fully materialise. This lag between policy changes and economic effects underscores the importance of maintaining a long-term perspective when making investment decisions.

This article was contributed by Michael Ajifowoke, Insights Associate at Daba.