The Beaten Down Areas That Could Benefit From Peak Rates

Last week’s surprise fall in UK inflation to 6.7% enabled the Bank of England to leave interest rates unchanged at 5.25% after 14 successive increases. It is possible that this will mark the peak in the cycle, although it will depend on whether the CPI continues to cool toward its two percent target and how the economy holds up.

The significant increase in interest rates in the last year or so has resulted in many investment trusts de-rating sharply in terms of both their price and discount. If rates stay at this level and then eventually start to come down there are plenty of sectors and funds that are likely to benefit.

A recent research report from the analysts at Stifel has looked into this whole area and identified the parts of the market with the potential to recover. However, they are not expecting a sudden knee-jerk upswing in share prices, as so much damage has been done that it will take time for investors to regain their confidence.

Private Equity And The Small Caps

Listed private equity funds are particularly sensitive to higher interest rates given their highly leveraged structures and the implications of rising debt costs on company earnings. Another concern has been the risk of valuation write-downs as a result of the falls in the PE ratios of comparable small and mid-cap companies.

Stifel believe that any recovery in the small and mid-cap sectors should be helpful for private equity and sentiment should also benefit once it is clear that rates have peaked. They think that these factors will likely lead to a positive re-rating and narrowing of the discounts that are currently in the order of 30% to 40%.

The analysts expect the small and mid-cap funds to be one of the fastest areas to recover if we move into an environment of lower interest rates. Their preferred investment trusts in this area include Aberforth Smaller (LON: ASL) for value stocks and BlackRock Throgmorton (LON: THRG) for growth stocks.

Infrastructure And Renewable Energy

The infrastructure sector has seen some significant falls in recent months as a result of factors such as rising debt costs, attractive yields on other asset classes and the impact of bigger discount rates, although the latter has been offset by the positive effect of higher inflation and increases in the deposit rate assumptions.

The jump in gilt yields over the summer led to quite a sharp de-rating of the sector with Stifel calculating that the correlation between these two factors over the year to June was a massive -0.83. They assume that if gilt yields continue to fall it could lead to a positive re-rating of the various infrastructure funds, with investors taking the view that discount rates used in the valuation models have peaked.

Renewable energy trusts have also been impacted by the same factors affecting infrastructure with the share prices of these funds now implying discount rates of around 10%, which Stifel think appears relatively attractive. Once it is clear that interest rates and gilt yields have peaked there could be a change in investor sentiment, although it is likely to be a slow burn.

Biotech And Technology

Valuations of emerging biotech stocks remain at depressed levels and the analysts think it is a case of “when” rather than “if” we see a more sustained re-rating of these names, especially as a reversal of the rise in rates would be hugely beneficial to the sector. They say that International Biotech (LON: IBT) and Biotech Growth (LON: BIOG) are both overweight in the small and mid-cap space and should outperform should there be a resurgence.

Stifel believe that the latter would benefit the most in this scenario due to its particularly high weighting to small caps, though they prefer the strategy of International Biotech, which is outperforming in varying market conditions, as well as over the longer term.

Technology funds have been one of the best performing sectors over the year due to the excitement around AI, with the US-focused tech funds – Polar Capital Technology (LON: PCT) and Allianz Technology (LON: ATT) – both benefitting despite being underweight in the large caps. Stifel think that if interest rates decline the strength in tech would broaden out with the small and mid-cap stocks benefitting the most, a scenario that would result in the outperformance of these funds and see their 14% discounts narrow.