The Fed’s rate cut is making UK equities look attractive

Since 2020, markets have seen huge swings in volatility. Covid, conflicts in Ukraine and the Middle East, the regional banking crisis in the US, and the interest rate cycle have caused asset prices to gyrate wildly. Numerous strategies have moved in and out of vogue as investors have wrestled with an unclear outlook and hunted for the best places to commit their capital.
The net effect of this uncertainty, combined with the fact that the success or failure of global equity portfolios has essentially hinged on whether or not you hold a handful of US tech stocks, has been that many types of funds found themselves experiencing heavy outflows as investors switched to “risk off” mode.
One corner of the fund universe, conversely, has grown serenely and inexorably during this period. Money market funds, vehicles designed to deliver a small upside to cash by investing in short-term, high-quality bonds and cash equivalents, have ballooned.
Somewhere in the region of $1.5 trillion has flowed into these funds since central banks started raising rates in 2021 and, as a result, the higher, stable returns available in money markets have appeared attractive compared to the chaos elsewhere.
Given that their raison d’être is to deliver a mundane return in a boring and predictable way, very little attention is paid to money market funds. But they might be about to trigger a sea-change in markets.
The interest rate-cutting cycle is well under way in the US, Europe, and the UK.
While the Federal Reserve’s half a percentage point rate cut this week didn’t generate the euphoric reaction many were expecting, the path for further cuts is still assured. Investors are like children in a sweet shop, always wanting more, more, more. But, once the sugar rush and foot stomping die down, they will recognise the reality that the recession risk has collapsed, and asset prices have been given a long-lasting shot in the arm. This could herald a reversal of the great rush into money market funds.
This isn’t just some technical quirk. US money market funds have about $6.3 trillion of assets under management. If the dam bursts on money market funds, a flood of cash will be released into other asset classes.
This can happen very fast. These funds invest in short-dated bonds, meaning yields reset quickly to market rates, rather than being locked in for longer periods. Central bank decisions affect these funds more or less in real time and they’re designed to be highly liquid, so investors access cash rapidly, too.
If, following the rate cuts, a torrent of capital leaves money market funds, the question is: where exactly will the money flow?
With some nagging concerns about the direction of the US economy, a fair amount of the money market wave will flow into bonds as some investors opt for a light tasting-menu of riskier assets rather than the punchy Chateaubriand of a full-blown pile into stocks.
Nevertheless, equity markets should see a significant bump. Historically, when the Federal Reserve cuts rates and growth holds up, equity markets perform very well. Yet the entry point for US stocks is expensive, with the S&P hovering around all-time highs.
Although the US economy’s glow-up could reflect some warmth onto global markets, the options available to investors are more akin to a rogues’ gallery than a beauty parade. China’s economic recovery looks distant. Despite attractive valuations, Latin America can be a minefield of political risks. Europe is the band with talented members but whose output is perennially held up by creative differences.
By contrast, although they look expensive, India, Taiwan, and Japan are likely to see inflows. India continues to benefit from multi-year economic growth. Taiwan will attract investor attention due to its leadership in the chips and semiconductors that power AI. Japan has faced some headwinds, such as currency volatility, but the prospect of reflation means it still looks interesting.
And, dare I say it, so does the UK. It benefits from cheap valuations, falling rates, and is home to 48 real estate investment trusts, which have been hammered in recent years but typically perform well in a rates downcycle.
The prospect of a windfall of capital from global investors might even encourage our latterly stony-faced chancellor to crack a smile. Unless, of course, she scares them all off with tax rises.
Seema Shah is chief global strategist at Principal Asset Management