US funds sector review – will interest rates keep climbing in 2023?

There are signs the US Federal Reserve (Fed) will carry on raising interest rates during 2023. Rates have risen eight times since March 2022, including four rises of 0.75%. It’s been the quickest rate rising cycle since the 1980s.

The pace of rate rises has slowed more recently though. The latest 0.25% increase in February was more in line with what we’ve seen in the past.

Why have US interest rates risen?

Interest rates have gone up as the central bank tries to tame inflation and bring it back down towards its 2% target range.

Central banks have often raised interest rates to take the heat out of an economy and reduce demand. It increases the rewards for savers looking to earn interest on their cash and makes it more expensive for consumers and businesses to borrow money.

However, it’s a balancing act. The Fed has to balance slowing the economy to tame inflation with the risk of going too far and slowing growth to the point of tipping the economy into recession.

Jerome Powell, Fed Chairman, recently said the path to US inflation decreasing was probably going to be bumpy.

Is inflation stickier than first perceived?

It’s clear the Fed’s decision to tighten monetary policy and increase interest rates are starting to have an effect on demand. Inflation peaked at 9.1% in June 2022 and has decreased seven months in a row since to stand at 6.4% at end of January. Falling inflation and a slowing pace of rate rises is likely to be positive for markets.

The consecutive falls in inflation had fuelled the fire that the Fed had inflation under control and heading in the right direction. The expectation that the Fed could begin to hold rates as they are and even potentially cut rates later in year were rising.

However, strong economic data suggests inflation will be more persistent than the market was hoping.

Although headline inflation has continued to fall, it came in above market expectations. It was expected to fall to 6.2%, rather than the reported 6.4%. This was coupled with a seemingly robust labour market that created 517,000 new jobs in January, well above market expectations of 185,000, as the unemployment rate fell to 3.4%.

Investors are concerned the hot labour market will cause inflation to stick around for longer and lead the Fed to continue its rate hiking cycle.

Higher interest rates and the US housing market

Not only are rising interest rates usually bad news for stock markets, it tends to slowdown the housing market. That’s because higher interest rates have tended to mean higher mortgage repayments.

This can be a useful tool for the Fed as homeowners spend more on their mortgage payments and have less income to spend on other goods and services. This helps slow the economy and lower inflation.

The challenge the Fed has is that the US housing market is dominated by long-term fixed-rate mortgages. This means most homeowners aren’t seeing their mortgage repayments increase, so can still spend the same amount on goods and services.

However, the housing market is slowing down. That’s because of the higher repayments associated with entering new mortgages or refinancing current ones.

Issuers interest rates for new mortgages have increased significantly over the last 12 months. So, while homeowners can still afford to pay their current mortgage, if they were to move house and borrow the same amount to finance the move, their mortgage repayments would increase.

The result of this is new house sales have decreased significantly, as has the average home sale price. Aside from being bad news for companies in the housing industry who’ll make less money, a slowing housing market also negatively affects consumer confidence.

How have the US Wealth Shortlist funds performed?

Investing in these funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio. Investments and any income they produce will rise and fall in value, meaning you could get back less than you invest.

For more details on each fund and its risks, you can use the links to their factsheets and key investor information below. Past performance is not a guide to the future.

The strongest performer out of our Wealth Shortlist US funds over the last year has been the FTF Royce US Smaller Companies fund.

The fund rose 13.97% over the past 12 months*, outperforming the Russell 2000 index, as well as the IA North American Smaller Companies peer group average. Performance was helped by the funds ‘value’ style of investing coming into favour as the market rotated away from ‘growth’ in 2022. Smaller company funds can carry additional risks compared to larger funds.

Value versus growth investing – the great rotation and what’s next

The weakest performer over the past year was Baillie Gifford American, having lost 23.08% over the 12 months to the end of February 2023. The managers’ growth-focused investment style has fallen out of favour with investors.

The fund has struggled as high inflation and rising interest rates have made investors question the future prospects and earning potential of the high growth companies it invests in. As a result, share prices of the fund’s investments have fallen significantly.

The fund aims to invest for the long-term with a concentrated portfolio including some exposure to smaller companies. Both of these factors increase the risk of the fund. The focus on growth in the fund can also lead to some periods of short-term volatility.

Because of the potential volatility, we think investors should focus on the long term when considering this fund. The fund aims to outperform its benchmark over a five-year periods, although this is not guaranteed.

We don't expect all the funds on the Wealth Shortlist to perform in the same way. We think it's important for investors to build a portfolio filled with managers who have different approaches and investing styles to help generate long-term returns.

Past performance is not a guide to the future. Source: *Lipper IM, to 28/02/2023.

Past performance is not a guide to the future. Source: *Lipper IM, to 28/02/2023.

MORE ABOUT FTF ROYCE US SMALLER COMPANIES INCLUDING CHARGES

FTF ROYCE US SMALLER COMPANIES KEY INVESTOR INFORMATION

MORE ABOUT BAILLIE GIFFORD AMERICAN INCLUDING CHARGES

BAILLIE GIFFORD AMERICAN KEY INVESTOR INFORMATION

Fund Insight: our weekly email

Sign up to receive our expert fund research and insights.