How could higher interest rates impact your portfolio?
Rock bottom interest rates were brought in as emergency life support for a floundering global economy during the financial crisis. No one expected that they would be in place as long as they have been, and markets have become dependent on the easy money environment central bankers created. The path back to normality presents many risks, and investors will have to take a pragmatic approach to navigate the changes ahead.
Interest rates are a tool used by central banks like the Bank of England (BoE), the European Central Bank (ECB) or the US Federal Reserve to control inflation and boost the economy. When a bank is concerned that the economy is expanding too quickly and pushing up prices and inflation, it can raise rates to discourage borrowing and cool the economic growth. On the other hand, if the economy is slowing down, lower rates can be used to encourage borrowing and spending and kick start growth. UK interest rates are currently at a low not seen in the BoE’s entire 323-year history, a response to the global financial crisis of 2008 and then to the 2016 UK vote to leave the EU.
The base rate affects many financial products, including mortgages, credit cards and interest rates on savings accounts. When it goes up, borrowing becomes more expensive for banks, so they push up the rates for consumers on their financial products. It’s good news for savers if banks also increase the rate they pay on cash on deposit. Rates have been below the rate of inflation for so long that many people’s savings pots have been gradually eroded as the cost of living outpaces the interest their savings can earn.
Higher rates could be seen as a good thing for equities because they signal economic recovery, which potentially means bigger company profits and better stock market performance. Certainly, the US stock markets have done well since the US Federal Reserve started to gradually raise rates from their post-2008 lows. But higher rates can also mean companies’ cost of borrowing goes up so their profits end up squeezed if they are highly indebted. Interest rate rises are also bad news for companies known as ‘ bond proxies,’ such as utilities, consumer staples, property and pharmaceutical stocks. These steady, stable, dividend-paying companies have acted as a popular replacement for bonds in a low yield, low interest rate environment, as investors searched for income. But these defensive sectors could be hit hard when rates rise, growth slows and investor sentiment turns. Some investors will return to bonds, while others may go for interest rate sensitive, beaten up cyclical stocks like banks, consumer discretionary and infrastructure.
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Although the developed world’s major central banks are thought to be heading more towards a monetary policy tightening path, meaning they will raise rates and stop printing money to pump into the economy, any sudden or swift hikes are unlikely. The banks know all too well that rate increases can trigger volatility, and they want to avoid shocking the markets and the economy. This means any increases will be well flagged in advance and, unless there is a sudden inflation spike, they will be small and gradual to give the economy a chance to normalise from the effects of years of artificial stimulus in the wake of the financial crisis.
The connection between interest rates and bonds is fairly clear cut. Bond yields are correlated to interest rates — they go up when rates go up, and vice versa.
In recent years, prices on some safe haven bonds rose so much that yields turned negative, meaning people were effectively paying to lend their money to governments. But now, yields are starting to rise. As this crowded trade unwinds, it could cause liquidity issues in the bond market. Government bonds with longer maturity dates will be more affected by rising interest rates, so holding shorter-dated bonds could be a way to reduce the interest rate sensitivity of your portfolio. You could also hold floating-rate bank loans, the yields on which move in line with interest rates. If you invest in funds rather than individual securities, holding a strategic bond fund where the manager has the flexibility to change their interest rate exposure could be a good tactic.
Property, as a growth asset, has characteristics of both bonds and equities, and also gives a fixed income from rents. While it is exposed to interest rate changes, it is also linked to economic growth so, if rates are going up because the economy is strengthening, that could prove to be more beneficial to property. This asset class tends to be less correlated to long-dated government bonds, and yields have held up better than those in the bond market. Income from property tends to rise as interest rates rise, the economy improves and demand grows.