Markets respond unpredictably to rapidly evolving events

The Russia-Ukraine war exemplifies how localised conflicts can send shockwaves across the globe. The conflict has disrupted critical supply chains for energy and agricultural commodities, particularly since both nations are key exporters of natural gas, wheat and sunflower oil. This disruption has raised costs and strained economies that were already reeling from the aftermath of the pandemic.

Concurrently, China’s assertiveness in the South China Sea has heightened geopolitical anxieties, impacting trade routes and adding uncertainty to international shipping and production networks. Meanwhile, unrest in Gaza and Houthi rebel attacks on vessels in the economically significant Red Sea have further escalated energy and shipping costs.

The interplay of these conflicts has significantly contributed to the resurgence of global inflation. Escalating prices for agricultural products, energy and freight have undermined recovery efforts in numerous nations, leaving households contending with higher living costs. Inflation, which had remained subdued for years, has surged as the cumulative impact of supply chain disruptions, elevated commodity prices and increased transportation costs exerts upward pressure on prices worldwide.

Interest rates and the unexpected speed of change
Among all the economic repercussions these events have triggered, one of the most significant for investors is the dramatic shift in interest rates. For over a decade, economies worldwide enjoyed a period of historically low interest rates. In the wake of the 2008 financial crisis, central banks reduced rates to almost zero to stimulate growth, making borrowing inexpensive and nurturing the longest bull market in history. This resulted in an investment climate where risk assets thrived and debt-financed growth became the standard.

However, the resurgence of inflation compelled central banks to act decisively to restore stability. While it was widely recognised that the era of ultra-low interest rates was unsustainable, few anticipated the speed at which rates would rise. Central banks, particularly the Federal Reserve, embarked on an aggressive series of rate hikes to combat inflation. This swift action took even seasoned investors by surprise. Markets, which had grown accustomed to gradual policy changes, were now faced with a new reality where central banks prioritised controlling inflation over economic growth.

Significant implications for global investment markets
The rapid increase in rates has significant implications for global investment markets. Bond yields, which were historically low, have risen substantially, leading to steep declines in bond prices. Equities, particularly in the high-growth tech sector, have come under pressure as the cost of borrowing increases and higher discount rates influence valuations. Furthermore, real estate markets have begun to feel the strain as mortgage rates surge, dampening demand.

But why does this matter to you as an investor? Interest rate changes ripple through financial markets, affecting sectors and instruments differently. Investment trusts, a popular choice for many private investors, have been particularly impacted by these high rates and hold potential opportunities.

What are investment trusts?
Investment trusts are a type of collective investment fund that differ from mutual funds in their structure. Commonly known as ‘closed-end’ investments, they issue a fixed number of shares that are traded on stock exchanges, enabling their prices to fluctuate according to market demand, rather than simply reflecting the value of the underlying assets.

This distinctive structure gives investment trusts a dual nature. On the one hand, they offer diversification, professional management and access to a wide range of asset classes. On the other hand, their prices may diverge from the actual Net Asset Value (NAV) of the portfolio, potentially presenting opportunities or challenges for investors, depending on market conditions.

How high interest rates have changed investor behaviour
When interest rates approached zero, many investors regarded investment trusts as an attractive alternative to fixed-income investments that offered minimal returns. Trusts concentrating on infrastructure, property and other alternative assets gained popularity as substitutes for fixed-income securities.

However, as interest rates began to rise, fixed-income investments became more attractive, leading to a significant sell-off of these previously favoured trusts. This shift had a profound impact; trusts, which once traded at a premium, transitioned to a discount. At the same time, sectors such as property and growth shares experienced considerable NAV pressure.

The ‘double whammy’ effect
The selling pressure on investment trusts resulted in what can be described as a ‘double whammy’. Firstly, as investors sold off shares, trust prices dropped below their NAV, creating substantial discounts. For example, some trusts that were once trading at premiums of 10-15% began trading at discounts of 15% or more.

Secondly, liquidity concerns compounded the situation. Many of the affected trusts were less liquid, meaning a relatively small volume of selling activity caused disproportionate price declines. Combined, these factors negatively shifted investor perceptions, casting doubts over the stability and value of certain investment trusts.

When will interest rates decline?
A central question dominating discussions among investors today is when interest rates might begin to decline. The timing of such a shift hinges on several interconnected factors, including inflation trends, economic growth and central bank policies. For central banks to consider lowering rates, inflation must consistently show signs of stabilisation near target levels, typically around 2%.

Furthermore, evidence of weakening economic activity, such as slower job growth or reduced consumer spending, could also prompt a more accommodative monetary stance. External factors, like the resolution of geopolitical tensions or improvements in global supply chains, might help ease commodity prices and support the argument for rate cuts. However, central banks remain cautious, as acting prematurely could risk reigniting inflationary pressures. This delicate balancing act leaves investors closely monitoring economic indicators and central bank statements for any indications of a change in monetary policy.

Lower rates would reduce borrowing costs
If interest rates begin to decline, the implications for investment trusts could be significant. Lower rates would not only reduce borrowing costs for these trusts but also make their dividend yields more appealing compared to fixed-income alternatives such as bonds. Investment trusts that specialise in income-generating assets, including real estate, infrastructure or dividend-paying equities, may attract increased investor interest as demand shifts back from fixed-income securities.

Moreover, falling rates typically support equity markets by enhancing corporate profitability and reducing the discount rates used in valuation models, thereby boosting the performance of trusts with equity-heavy portfolios. For trusts employing leverage, lower rates would minimise financing costs, enhancing overall returns. Ultimately, a sustained period of decreasing rates could restore investor confidence, making investment trusts a more appealing option in a recalibrated financial landscape.

Seizing potential opportunities
Despite the current pause in momentum, the long-term outlook for investment trusts remains optimistic. For discerning investors, the substantial discounts at which many trusts are trading present a tempting opportunity. These discounts create potential upside for those willing to adopt a patient, long-term investment strategy. Historically, periods of uncertainty and unattractive valuations have often provided fertile ground for future gains. Savvy timing, particularly regarding potential interest rate cuts, could allow investors to capitalise on significant returns as market sentiment improves and valuations normalise.

One of the standout advantages of investment trusts is their access to a broad and diverse range of asset classes. Unlike conventional equity funds, investment trusts can open doors to alternative areas such as renewable energy infrastructure, private equity and emerging markets. These sectors often operate independently of traditional market cycles, providing investors with resilience and the opportunity to capture growth in niche but vital parts of the global economy.

Renewable energy infrastructure trusts well-positioned
For instance, renewable energy infrastructure trusts are well-positioned to benefit from the ongoing transition to clean energy, supported by government backing and the rising demand for sustainable solutions. Similarly, private equity trusts enable individual investors to participate in high-growth opportunities typically reserved for institutional players, while emerging market trusts leverage the rapid expansion of economies that may outpace developed markets in the future.

For investors with specific goals or unique risk profiles, these varied exposures present tailored opportunities to maximise returns. They provide resilience in volatile markets and position portfolios to benefit from changes in macroeconomic trends.

THIS ARTICLE DOES NOT CONSTITUTE TAX, LEGAL OR FINANCIAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. TAX TREATMENT DEPENDS ON THE INDIVIDUAL CIRCUMSTANCES OF EACH CLIENT AND MAY BE SUBJECT TO CHANGE IN THE FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.

THE TAX TREATMENT IS DEPENDENT ON INDIVIDUAL CIRCUMSTANCES AND MAY BE SUBJECT TO CHANGE IN FUTURE.