Interest rates are likely to peak this year, leading to a rebound in growth stocks, however investors should be careful if inflation turns out to be sticker than expected.
Markets are currently pricing in a rate peak of slightly above 5 per cent in July this year in the US, with one interest rate cut by the year-end.
Although the expected pace of cuts has slowed since the start of the year, mainly due to a boom in the US jobs market in January, investors still believe we are near the peak of interest rates.
This is at odds with the communications from the Federal Reserve, which has reinforced the message that it does not think inflation will drop quickly this year.
For the end investor, this could mean a continuation of the benefit of holding bonds.
“If you believe the markets are right, there is still quite a lot of value in fixed income,” said Darius McDermott, managing director of Chelsea Financial Services.
The turmoil seen in bond markets towards the end of last year has resulted in a number of opportunities for investors which analysts said had not been seen since 2008.
Corporate bonds have been returning to favour with investors as the rise in interest rates provides a better return.
Some 51 per cent of 441 fund selectors questioned by Natixis said they are planning to increase their exposure to government bonds, with 46 per cent saying they will invest more in investment grade corporate bonds.
“You can rely a bit more on fixed income in this part of the cycle for diversification as well as income,” McDermott said.
However, the main concern for investors is that markets are wrong about inflation.
Two fifths of European fund managers surveyed by Bank of America for their latest survey have said the biggest tail risk (the risk of an asset losing value due to a rare event) is that inflation stays high, with 17 per cent pointing to worsening geopolitics.
Fund managers' biggest tail risk concerns
Source: Bank of America
Growth is getting better
If and when the base rate of interest is cut, certain growth companies will also benefit.
Valuations across the growth sector have plunged since interest rates were tightened, with Baillie Gifford saying at the end of last year that the markets had thrown growth companies out “with the bathwater”.
McDermott said: “Some of these fast-growing companies are still growing just as fast as they were, and in some cases faster, but their share prices are down between 50 per cent and 70 per cent.”
In a report last week, Stifel said if inflation cools quicker than expected, investors will be more comfortable backing early-stage, high-growth companies if inflation and interest rates have peaked.
According to Bank of America’s latest survey, the share of European fund managers who think value stocks will outperform growth has dropped from 41 per cent to 8 per cent.
