• Markets are pricing in an interest rate rise on Thursday
• They may be disappointed - the MPC has good reasons to wait
• Impact of interest rate rises on funds, markets and investors
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“The market is convinced the Bank of England is going to raise interest rates this week, but the interest committee might want to take a deep breath and count to ten before pushing the rate hike button. There are some compelling reasons why the Bank might wait before tightening policy, and it was only six weeks ago that the Monetary Policy Committee voted unanimously to keep interest rates on hold, so a shift to tighter policy would be a sharp U-turn indeed. The Bank’s judgement that inflation is transitory hasn’t really been tested, as it’s only six months that CPI has been marginally above target, and in fact the inflation index fell back at the last reading. The data is notoriously unreliable at the moment, thanks to the distortions created by the pandemic, and a synchronised emergence from it in Europe and America.
“The energy crunch has deepened since the committee last met, but is still relatively short-lived, and gas prices have actually been falling in recent days as more supply looks to be coming online from Russia. In any case, an interest rate rise in the UK isn’t going to make a blind bit of difference to the global price of oil and gas, though it will heap a bit more pressure on UK consumers at a time when many will be facing higher costs to heat their homes and travel to work. Larger mortgage payments would be an unwelcome extra burden for many UK homeowners. Rising energy costs themselves act as a brake on consumer and business activity, and the Bank may well decide that pouring more cold water on the situation at this juncture could lead to an economic freeze.
“While the cloudy economic data might stay the Bank’s hand this week, an interest rate rise is very much in the post. A rate hike isn’t suddenly going to mean money is expensive to borrow, and 0.25% would still be an incredulously low rate, even below the ‘emergency’ rate of 0.5% introduced in the wake of the financial crisis. A sustained tightening cycle would represent a paradigm shift in markets, however. We’ve only had two interest rate rises in the last fourteen years, and we estimate around 10 million Britons have never seen base rate above 1% in their adult lives, based on ONS data. Markets have already begun to price in the end of the era of cheap money, and investors would be prudent to review their portfolios for potential casualties of tighter monetary policy. Interest rates are still likely to stay low by historical standards for a long time, but market prices may well adjust more rapidly.”
Why the Bank might not raise interest rates
Dodgy data – economic data has been distorted by the pandemic and this muddies the water for the Bank of England. No matter how good your economic models, if you put garbage in, you’ll get garbage out. The latest fall in CPI resulting from the Eat Out to Help Out scheme disappearing from the annual comparison highlights the difficulty of getting a good read on the true state of the economy right now. This will be the first interest rate committee meeting since the furlough scheme ended, so the Bank may well want to see how the jobs market looks without a large sticking plaster obscuring its view. Even the latest rosy assessment of the UK’s economic prospects from the OBR still forecasts a rise in unemployment from the current level of 4.5% to 5.25% this winter, and the Bank’s predictions might follow suit.
Controlling the wrong inflation - much of the inflationary pressure building in the economy is coming from global supply issues and higher energy costs. A rise in UK interest rates is going to do nothing to alleviate those issues, beyond a very modest boost for the pound. The Bank still sees these issues as transitory, so it’s unclear why there should be a shift in policy while that is the case.
Budget bonanza - it was only last week that the Chancellor announced a huge spending splurge, and the Bank of England would be wise to take some time to properly consider what effect this may have on price rises. Overall the Treasury’s spending plans look inflationary, particularly when combined with a rise in the National Living Wage. There are deflationary elements to the fiscal plan laid out in the last two Budget’s however, in particular the freezing of tax thresholds and the rise in corporation tax will restrain consumer and business spending, and the allocation of some of the Chancellor’s economic windfall to paying down debt. Given the short turnaround between the Budget last week and this Thursday’s MPC meeting it seems unlikely the committee will as yet have had sufficient time to analyse the impact of the Chancellor’s policies.
Asymmetric firepower – the Bank of England has plenty of firepower to deal with inflation. Rates are so low it has huge scope to tighten policy, but it has almost no room for manoeuvre in the opposite direction. That is one good reason that in the longer term rates should rise, so that the Bank can once again stimulate the economy if needed. The tricky balancing act for the Bank is to rebuild that firepower without tipping the economy into a state where it needs to be stimulated.
Impact of rising interest rates on funds, markets and investors
Equity investors – equities won’t take kindly to an interest rate hike in and of itself, but rising interest rates are a sign the economy is in more robust health, and that should be good for corporate earnings. The worst case scenario for equity markets is stagflation, where interest rates rise simply to fend off inflation, but the underlying economy is going sideways, making it harder for companies to grow their sales. Equities are a better place to be than bonds in a tightening cycle however, and at least offer protection from inflation over the long term, which should help to underpin share prices.
Indebted companies - a rate hike would increase the interest bill paid by companies on their borrowings, so those with largest debt piles would find their earnings worst hit. Pension contributions for legacy finance salary schemes could also rise, as these are linked to bond yields. These effects would likely take some time to feed through, as pension funding is reviewed only once every three years, and corporate debt refinancing at higher rates will also take place gradually over a number of years as cheaper, older debt matures, to be replaced with more expensive borrowing.
Tech and growth stocks - more immediately, stock valuations might get clipped back by a rise in the risk-free rate - determined by government bond yields, especially in the US. Those companies with valuations based on more distant earnings streams, like some tech companies, could find themselves at the sharp end of proceedings.
‘Bond proxies’ - would also likely see share prices come under pressure, as investors are tempted out of companies like Unilever, Johnson & Johnson and the utilities sector, and back into their natural habitat of bonds, as yields rise and therefore offer better relative returns. The share prices of these companies have done exceptionally well in a low interest rate environment, but they will find the going gets tougher if monetary policy tightens.
Banking sector - higher interest rates would be good for banks. The ultra-low interest rate environment has compressed the interest margin between deposits and loans, which are a bedrock of profits for commercial banks. Bad loans shouldn’t tick up too much, as any interest rate rises are going to be very gradual. The slow pace of tightening policy means bank profits aren’t going to skyrocket overnight, but shares may well appreciate as the market prices in a better monetary backdrop for the sector.
Smaller companies - in theory, smaller companies are more fragile than their blue chip cousins, as they have less robust earnings streams and access to capital. In some cases, higher interest rates would increase their debt burden, and could push them further towards the cliff edge of losses and insolvency. Their stock prices are often predicated on longer term growth too, and so higher interest rates and inflation could mean we see some valuations pegged back. That’s particularly the case seeing as the UK’s small cap index has been hitting record highs of late. However, not all smaller companies carry significant levels of debt. And while smaller companies aren’t immune from what’s going on in the wider economy, the drivers of growth are more secular and idiosyncratic, which can bolster share prices even in troubled times. The long term performance of this section of the market has also been exceptionally strong, particularly when partnered with active fund management.
Residential property - higher mortgage rates should take some of the steam out of the housing market. Prices could fall, but a moderation of price growth seems more likely, given the ongoing imbalance between supply and demand, and the presence of continued government support in the form of Help to Buy and the Mortgage Guarantee scheme. The Bank of England certainly won’t want to put so much strain on the economy that homeowners are posting their keys through the letterbox as they leave, because they can’t afford mortgage payments.
Commercial property – commercial property prices could also come under pressure from interest rate rises, which heap pressure on tenants by increasing their debt bills. If the economy is in fine fettle though, that should mean businesses can afford the extra costs, though the good times may not be split fairly amongst all sectors. As an asset normally held for income, the commercial property sector may see outflows if bonds and cash start offering a more attractive yield. That could spell more trouble for the open-ended funds invested in commercial property, where large outflows might increase the risk of trading suspensions. The sector is already on tenterhooks waiting for the FCA to announce if notice periods will become mandatory, which could also prompt an exodus from the sector.
Taxpayers - rising interest rates would also be extremely negative for government finances, and by extension, the taxpayer. Government bond prices have already adjusted to the prospect for higher inflation and tighter policy, with the 10 year yield rising from 0.5% to 1% since the beginning of August. In ‘normal’ conditions, rising rates only affect new government borrowing, but today, the QE programme has effectively pegged £875 billion of government debt to the base rate. This is a floating rate that can change interest payments overnight, unlike the fixed rates of the gilt market.
Gilt investors - conventional UK government bonds are directly in the firing line if monetary policy tightens, either through interest rate rises or an unwinding of QE, which could be particularly painful as most investors choose bonds because they’re seen as safe havens. But twelve years of ultra-loose monetary policy has driven gilt prices so high, they now carry an awful lot of valuation risk, and offer a desultory yield in return.
Pension lifestyling fund investors – a subset of gilt investors, these investors are particularly at risk as they will probably never have made an active choice to invest in bonds. As these investors approach their stated retirement date, they are automatically shifted from equities into long dated government bonds. The idea is to hedge annuity rates, which move in line with bond yields. Of course, since the pension freedoms were introduced, very few people now buy an annuity. But these lifestyling programmes, potentially set in train 20 to 30 years ago, are still robotically moving people into gilt funds nonetheless. Any falls sustained in the value of these funds should be offset by rising annuity rates. But then, that’s not much use if you’re not buying an annuity.
Corporate bonds - Unlike gilts, corporate bonds (both investment grade and high yield) carry a higher interest rate, which helps cushion the impact of price falls emanating from fears of tighter monetary policy. They also tend to be shorter dated, which means they are less sensitive to interest rate rises. Being loans to companies rather than governments, they also experience some upward pressure on prices from an improving economy, because the accompanying earnings growth should make it easier for companies to service their debt. In a rising interest rate scenario, these ‘riskier’ bond funds should therefore fare better than ‘safer’ gilt funds, but they still might see negative returns.
Gold investors – higher interest rates aren’t good for gold because it pays no income. That’s much less of an issue when rates are close to zero, and so the opportunity cost of holding an asset with no yield is virtually nil. As interest rates rise, that cost becomes heavier to bear, and cash and bonds become more attractive as safe havens. It’s interest rates in the US which are more important to the gold price than in the UK however. The gold price peaked at over $2,000 an ounce last summer, and has now fallen back to around $1,800, as market optimism has lessened demand for safe havens.
Moneymarket funds – these cash like funds saw £1.6 billion of inflows in August, which is more than they see in most years. Most of that can probably be accounted for by cautious multi-asset funds fleeing bonds, and in the short term we can probably expect to see more money heading into moneymarket funds. Rising interest rates should lead to higher yields in the sector, but like cash, the ascent is likely to be painfully slow, so, it’s going to take a number of rate hikes before these funds offer a reasonable rate of return, particularly when you take charges and inflation into account.
Absolute return funds - rising interest rates are a double-edged sword for absolute return funds. These funds tend to hold large sums of cash to offset derivative positions, and so higher rates will feed through into more interest flowing through into returns. However, the target return for many funds is based on LIBOR, so rising interest rates will mean many absolute return funds have a higher hurdle to clear to beat their benchmarks, and potentially collect the performance fees which are common in the sector.
