The impact of
Interest rate
Asset class
How interest rates affect the economy
Central banks tend to aim for maximum employment and stable prices by managing . In other words, central banks, like the Bank of England (BoE), use interest rates as a tool to keep inflation and unemployment in balance.
Lower interest rates make borrowing cheaper, encouraging people and businesses to spend, borrow and invest, which helps stimulate the economy to grow faster. On the other hand, when rates are high, people and businesses are encouraged to cut costs and save. Central banks cut rates to slow down economic activity by making borrowing more expensive.
Rate cuts occur when central banks are worried about low growth or high unemployment, while rate hikes indicate they’re worried about high inflation. This was evident during the COVID-19 pandemic when supply chain disruption and government spending drove inflation to 11% in 2022.
The impact of interest rate changes on investment portfolios is an important factor to consider, as different assets react differently to rate adjustments.
Impact of interest rate changes on bonds
Bonds are highly sensitive to interest rate changes. When interest rates rise, newly issued bonds offer higher returns, making older bonds with lower rates less appealing. As a result, the prices of the existing bonds drop because investors prefer the returns offered by the new bonds.
The term duration refers to a bond’s sensitivity to changes in interest rates. The duration of a bond determines how much its price will move in response to interest rate changes. Bonds with longer durations are more sensitive to rising rates. For example, if rates rise, the value of long-term bonds will fall more than that of short-term bonds. To protect the value of a bond in such environments, we keep our bond portfolios shorter in duration.
Conversely, when interest rates are expected to fall, holding longer-duration bonds can be beneficial because the older bonds, with higher interest rates, will become more valuable compared to the new, lower-rate bonds. In this lower interest rate environment bonds with higher interest payments suddenly become more valuable.
Given the impact of rising interest rate changes on bonds, as interest rates were rising over the last few years, we kept the duration of our bond portfolios shorter to minimise potential losses from falling bond prices. In other words, our portfolios have been “underweight” in duration during that period.
Impact of interest rate changes on equities
Equities are shares of ownership in a company; buying equities is essentially buying a small piece of that company. Interest rates are often compared to an accelerator pedal in the context of equities: when rates are low, it’s like pressing the pedal down and accelerating their growth. Companies focussed on growth and innovation tend to perform better in this type of environment.
Conversely, when interest rates rise, companies that depend on future growth—like those in the technology sector—can struggle because their future profits are worth less in today’s terms, causing their stock prices to drop.
On the other hand, companies that already generate strong cash flows, such as those in mining, financial services or energy, tend to weather rising rates more effectively. However, many of these businesses don’t align with the values-driven approach of impact investing, which focuses on innovation and long-term growth.
It’s also worth noting that during periods of falling rates, small and mid-sized companies have historically outperformed the broader market, benefitting from easier access to financing.
Context matters
While understanding the impact of interest rate changes on investment portfolios is crucial for effective portfolio management, the context behind an interest rate cut is crucial too. Interest rates are typically reduced in response to economic slowdowns (recessions) or to support long-term government objectives like job creation.
Since 1970, the US Federal Reserve has initiated 18 rate cutting cycles. 11 of these were in response to expected recessions. When the Federal Reserve cuts interest rates in response to a potential recession, the stock market often reacts with an immediate drop, or ‘sell-off,’ as investors worry about the economic slowdown to come. However, after this initial decline, the market tends to recover.
What does the data say?
On average, over the 12 months following these rate cuts, the US stock market has delivered an 8% return. That said, the actual outcomes have varied widely, with the worst return being a loss of 36% and the best a gain of 34%.[1] While interest rate cuts often lead to eventual recovery, the short-term reactions and the size of returns can be unpredictable.
The remaining seven rate cuts were non-emergency or ‘celebratory’ cuts. These happen when the economy is already doing well, and the central bank lowers rates to encourage further growth rather than to prevent a downturn. In these cases, the market response tends to be more positive and less erratic. On average, the stock market returns 11% over the 12 months following celebratory cuts. The range of outcomes is also more stable, with the lowest return being a loss of 5% and the highest gain reaching 18%.[2]
This suggests that, during non-crisis rate cuts, investors generally see steadier and more reliable gains compared to cuts made during economic trouble.
Given that the current rate-cutting cycle appears to be celebratory, and knowing small and mid-sized companies generally perform well in such environments, we expect strong support for many of the sectors we favour as sustainable investors.
Impact of interest rate changes on alternatives
Alternative investments, such as renewable energy projects or microfinance, react differently to interest rate changes than more traditional investments like bonds and equities. For example, securities like investment trusts that focus on providing income (or yield) in low-interest rate environments may become less appealing when interest rates rise. This is because safer investments in this environment, such as bonds, begin offering similar returns but at a lower risk level, making those trusts less attractive by comparison.
However, when interest rates fall again, investors tend to return to these alternative assets. This is because their prices typically drop during periods of rising interest rates, making them cheaper to buy once rates lower again.
On the other hand, some alternatives, like microfinance, tend to be more stable across different interest rate environments. These investments provide steady returns because they’re less affected by interest rate changes, making them a valuable part of a diversified portfolio, helping to balance out risk.
Looking ahead
With inflation easing and central banks in the UK and Europe beginning to cut interest rates, growth-oriented companies are becoming more attractive. This creates fresh opportunities for sustainable investors, as sectors focused on sustainable and long-term growth are likely to benefit.
Understanding the impact of interest rate changes on investment portfolios is essential for building strong, resilient strategies. And understanding how these interest rate changes affect different asset classes is key to managing well diversified portfolios. With the potential for falling rates ahead, sustainable investors may see brighter opportunities in the coming economic cycle.
[1] Ritholtz Wealth Management. Chart Book: The Rate Cut Playbook.
