The RBNZ’s quarter point cut to the Official Cash Rate (OCR) heralds the start of a new chapter in the economic cycle. Many developed economies are also beginning this new chapter as central banks become increasingly confident that the war on inflation has been won and restrictive interest rates can be normalised to more neutral levels.

Investors have been expecting this development, with market pricing for interest rate cuts appearing as soon as it was clear the hiking cycle was over. But now cuts are being delivered, what are the implications for investing?

Lower interest rates reduce the attractiveness of cash. With $218bn1 sat in term deposits in NZ, reducing interest rates should start to prompt these investors to consider alternatives. 1yr term deposit rates have fallen around 0.6% from their peak in Oct 2023, but at around 5.4% they still represent a reasonable investment. With the RBNZ expected to lower interest rates steadily towards 3% over the next year or so, it is likely that term deposit rates will continue to fall.

Falling interest rates are a boon for bond investing as bond prices rise when interest rates fall (the opposite of what happened from 2020 to 2023). With a period of falling interest rates looming, do bonds now represent a strong investment case? Bond markets have already priced in the cutting cycle and returns from bonds have been very strong over the past year. Indeed, a NZ government bond index2 has returned a healthy 17.5% since its trough in October 2023. With interest rate markets already pricing a return of the OCR to around 3%, bonds have largely pulled forward the returns from falling interest rates. Yields on offer from government bonds are comparable or lower than term deposit rates whilst modestly higher yields can be had from investing in corporate bonds. This is hardly compelling, but with global economic growth slowing, bonds could deliver strong performance if growth slows sharply, and interest rates are cut below the neutral level (approximately 2.5-3.5% for NZ).

What about shares? With relief for NZ borrowers finally coming, it is reasonable to expect our sluggish economy to pick itself up. The same optimism can be extended for other countries that are cutting interest rates. Should investors think about adding shares, particularly cyclical companies that can better harness improved economic growth? Here it pays to be discerning. Many global shares have performed well over the past year and elevated valuations don’t offer great entry points. NZ shares have lagged, and rate cuts should stabilise the outlook for domestic cyclicals. But business conditions will remain tough and cyclicals come with high risks should the economy not improve.

But there are investments that we think are increasingly attractive. Income shares, (typically companies that have strong cashflows from an established asset base) should perform well in a rate cutting cycle. We are finding examples of these in the domestic market, over the ditch in Australia as well as further afield. Milford’s funds (including Diversified Income Fund and Active Growth Fund) have been increasing exposure to these companies recently. From a geographical perspective, UK shares continue to screen attractively. They are cheap, unloved and should benefit from a rate cutting cycle that is less fully priced than in other countries. Milford’s funds have increased exposure to the UK, particularly banks and utility/infrastructure companies.

Changing outlooks demand a changing investment approach, we continue to find new ways to profit from this next chapter of the economic and market cycle.

 

  1. As per RBNZ data from June 2024
  2. S&P/NZX NZ Government Bond 5+ Year Total Return Index