Lower interest rates could benefit bonds (including both junk and investment-grade bonds), small and mid-cap stocks (which have been struggling for a long time), and European stocks (which are recovering from the economic slowdown and war).
That’s the message from Goldman Sachs Asset Management’s interim outlook, released on Tuesday, as we enter a new era of interest rate cuts. “Expected U.S. interest rate cuts have been repeatedly pushed back to the first half of 2024 due to inflationary pressures, while other central banks have signaled their intention to cut rates or have begun to do so,” Ashish Shah, Goldman’s chief investment officer for public investments, said at a press conference on Tuesday.
He warned that there remains great uncertainty, given conflicts in Ukraine and the Middle East, as well as the upcoming US presidential election, but said opportunities are opening up in many places, pointing to investments in artificial intelligence and sustainability.
Shah said the trend of falling interest rates continues, with the Federal Reserve expected to cut rates later this year, the Bank of England on track to do the same, the European Central Bank cutting rates in June and, according to the firm’s analysis, “Chinese policymakers are maintaining an accommodative trend.”
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Lindsay Rosner, global head of multi-asset fixed income at Goldman, said the threat of a recession appears to have faded, adding that recently “investors are not demanding excessive compensation for credit risk” and “corporate balance sheets are generally strong.”
Goldman strategists suggested opportunities could emerge in several areas:
Bonds. It’s axiomatic that when interest rates fall, bond prices rise. In Mr. Rosner’s view, some bonds are best served by lower interest rates. He points to investment-grade bonds from big banks (where lower rates allow banks to make more loans that earn fees and other revenue) and higher-yield bonds from industrial and energy companies (both of which need lots of debt, and continued healthy economic growth would benefit both sectors’ earnings).
Additionally, Rosner said, “AAA-rated collateralized loan obligations are backed by strong fundamentals and favorable technical terms, which make them attractive for carry.” Currently, loans to these highly indebted borrowers (leveraged loans) are doing well because default rates are low and interest rates are very manageable.
Small cap stocks. Smaller companies rely more on debt than larger ones, so lower interest rates are always a godsend for them. Shah noted that small-cap stocks generally enjoy higher profit margins and better reported earnings. The Russell 2000 Index has more than doubled since its pandemic lows in March 2020 and remains very affordable. The index’s price-to-earnings ratio of 25 is just above the S&P 500’s 22 and below the high-growth Nasdaq 100’s 29.
Of course, many of the Russell 2000’s constituents boast P/Es that are much lower than the index average. “U.S. small-cap stocks are poised for a recovery and offer attractive absolute and relative valuations,” Shah comments. “Small-cap companies have the potential to access the higher growth potential of future mid- and large-cap leaders.”
European stocks. After a period of weakness, European stocks are showing signs of recovery, according to Shah. Indeed, the STOXX Europe 600 (owned by ISS STOXX, which also owns CIO) is up just 8% this year, half the rate of the S&P 500. France’s CAC is only set to rise 1% in 2024 amid uncertainty over the country’s political direction ahead of a recent general election. But certain exchanges have fared much better, with Dutch stocks up 18% and Denmark up 25%.
Still, falling inflation has prompted the ECB to cut interest rates. The labor market is strong and wages are growing. “Improving growth and inflation in Europe, combined with improving corporate earnings and modest valuations, bode well for European equity markets,” Shah said.
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Tags: quoted investment grade bonds, ECB, Federal Reserve, Goldman Sachs, high yield, interest rates, leveraged loans, Russell 2000, S&P 500, small caps, STOX Europe 600
