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Low interest rates: what do they mean for our investments?

This month saw cuts to US and Chinese interest rates. All around the developed world, central banks are cutting interest rates or keeping them historically low, in a desperate attempt to stimulate economies in the face of economic and geopolitical distress.

In Europe, the interest rate is zero, while in Japan it is actually negative. In Denmark, even mortgage rates have gone negative, so customers now get paid to borrow.

Meanwhile, ongoing quantitative easing – printing money – from the Japanese and now European central banks, ensures that bond yields are kept low.

And the UK?

So, what does this mean for our investments here in the UK? Well, interest rates here are low and look like staying that way. This means we should avoid keeping too much cash in our bank accounts. With savings rates well below the inflation rate, any cash is effectively seeing its value eroded.

What are the alternatives? Low interest rates make gold more attractive to investors. It is a non-interest-bearing asset, so when rates are higher, investors tend to move out of gold and into areas where they can earn higher returns. But in the current environment, gold has been one of the best performing assets of the year, up 26% in 12 months. The yellow metal is seen as a safe haven in times of uncertainty. Given the current state of the world and the likelihood of rates staying lower for a while, gold is very attractive at the moment.

Investors do not have to buy the metal itself. They can gain exposure to the gold price directly through an exchange traded fund (ETF), effectively tracking the gold price. Alternatively, there are several gold mining companies listed on the London Stock Exchange, which might provide a more interesting, albeit riskier, investment.

I’m sticking with shares

Despite the appeal of gold, I prefer shares at the moment. All else being equal, lower interest rates should be a plus for stocks, with lower rates effectively increasing the value of future company cash flows – which is what analysts base their valuations on. Lower rates also cheaper borrowing and should, in theory, help companies finance capital investment, hopefully leading to higher future profits.

Lower interest rates also draw investment into the stock market from other areas of the financial system. As investors are no longer able to achieve the kind of returns they want from savings, and with bond yields also driven down, capital is drawn to assets like the stock market where there is the potential to earn higher returns. Quantitative easing only serves to magnify this effect by injecting more money into the system.

But there are some losers

Not all companies benefit from lower interest rates, with banks being one such group. Lower interest rates reduce banks’ net interest margin – the difference between the rate that they lend at and the rate that they borrow at – which is the traditional way that they make money. This hits the bottom line and is a key reason why Barclays, HSBC, Lloyds and RBS trade at such low valuations.

Low interest rates are very positive for commodities and stocks. But while a rising tide will lift most boats, it’s still as important as ever to pick the right investments. As always, diversification is key.

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Thomas Carr does not own shares in any of the companies mentioned. The Motley Fool UK has recommended Barclays, HSBC Holdings, and Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.