Guest author: What should investors watch out for in this hiking cycle?
Karen Ward
Chief Market Strategist EMEA at J.P. Morgan Asset Management
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Interest rates are on the up
Central banks in the West have woken up to the fact that inflationary pressures are building in their economies, and if they don’t collectively take their feet off the monetary accelerator then they could have an inflation problem on their hands.
The Russian invasion of Ukraine has created a difficult dilemma for central banks given the potential for slowing growth alongside rising inflation. (We recognise the human and geopolitical consequences of Russia’s invasion eclipse the economic ones and the cost of the war will be first and foremost a human one). But assuming the most adverse scenarios are avoided it seems likely that the recovery will proceed, and central banks will focus on tackling inflation.
Over the past few months there has been a dramatic repricing in short-term interest rates. Just three months ago the market expected the Fed and Bank of England to hike interest rates three times this year. Now about 7 hikes are priced. What does this mean for us investors?
Savers might rejoice at the prospect of finally seeing a better return on cash. We must remember, however, that what matters is the real interest rate – the rate of interest after inflation. The bad news is that while interest rates are set to rise, they are unlikely to keep pace with inflation. The market currently expects the Bank of England policy rate to get to over 2% at the end of the year. But inflation is still expected to be running north of 5%.
The market currently expects the Bank of England policy rate to get to just over
at the end of the year
But inflation is still expected to be running north of
A sustained period of elevated inflation will prove challenging for government bonds. The price of a ten-year gilt has already fallen over 5% this year. Longer-term bonds are faced with the double-whammy of rising policy rates and the withdrawal of the central bank’s asset purchase programmes. The central banks have acted as a major buyer in recent years. Indeed, last year the Bank of England conveniently bought all the government bonds the treasury needed to issue. In the not-too-distant future they may turn from a buyer to a seller which could exert further upward pressure on longer-term yields.
Corporate credit has the advantage of a higher coupon than government bonds and that income could cushion the capital loss as yields rise. However, that cushion - the spread of the yield on corporate bonds over government bonds - has become very low, reducing their ability to absorb rising government bond yields.
What about stocks?
This is the subject of lively debate in the market. The volatility of recent weeks shows that stock investors are nervous.
The bears say that central banks will choke off the nascent recovery; that even modestly higher interest rates, alongside higher commodity prices, will cause the economy to slow. Rather than merely easing off the accelerator the central banks will purposefully, or accidentally, slam on the brake. Stock prices will face the difficult double of earnings expectations falling while discount rates are rising.
The more bullish amongst us argue that earnings won’t slow and ultimately this will carry stock prices higher in the coming years. In my view, as Omicron risks recede, there is still considerable pent-up demand to be unleashed. Households have accumulated considerable savings in the pandemic and their house and financial assets have gone up in price over the past two years, so they are feeling wealthier. And with very little unemployment, they are feeling job secure and getting meaningful pay rises.
Higher energy prices will eat into some of that disposable income. But spending on energy bills, accounting for both car and heating fuel, accounts for just 5% of total consumer spending in the UK these days.
That being said some stocks will like rising interest rates more than others. Rising interest rates could dramatically change the patterns of market leadership relative to those we have experienced in recent years. During the last market cycle, the strongest stock returns were seen in technology and other growth companies. Regions whose benchmarks were heavily weighted towards technology – most notably in the US – were the clear winners.
In dollar terms, the S&P has outperformed the FTSE 100 by
percentage points since 2008
The earnings performance of these companies was part of the story. But this was exacerbated by low interest rates which reduced the discount rate to which these far off distant earnings were discounted.
This chart shows the historical correlation between longer-term interest rates and various equity benchmarks relative to the MSCI ACWI Index, shows that the former winners face a tougher time in a period of rising interest rates.
Correlation of equity markets with the US 10-year treasury rate
Source: MSCI, Refinitiv Datastream, J.P. Morgan Asset Management. Correlation of sectors is calculated between the six-month change in US 10-year Treasury yields and the six-month relative performance of each sector to MSCI All-Country World Index. Past performance is not a reliable indicator of current and future results. Guide to the Markets - UK. Data as of 31 December 2021.
Investors that rode the tech/growth/US bull market of the last decade may now find their portfolios heavily skewed towards these sectors and should think about rebalancing to sectors such as financials, industrials, materials and energy.
Investors are often reminded that past performance is not a good indicator of future returns. This is truer now than ever. As the forty-year bond bull market turns, investors should think hard about reshaping their portfolio for the future.
Investors that rode the tech/growth/US bull market of the last decade may now find their portfolios heavily skewed towards these sectors and should think about rebalancing to sectors such as financials, industrials, materials and energy.
Karen Ward, Chief Market Strategist EMEA at J.P. Morgan Asset Management
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