Base rate rise: implications for markets and investors

Laith Khalaf, senior analyst at Hargreaves Lansdown, considers the prospects for the pound, equities, bonds, cash, and property should interest rates rise tomorrow.

Base rate rise: implications for markets and investors

Markets are now pricing in a 90% chance of a UK interest rate rise tomorrow. High expectations on this front have been disappointed before and, even if they aren’t, a rate rise only takes us back up to 0.5%, where we were eighteen months ago.

However the prospect of an environment of rising interest rates is one which investors should be alert to, and what follows are some tips for investors and some thoughts on how tighter monetary policy could impact on asset prices, whether we get a rate rise tomorrow or not.

It’s also important to note that interest rates rises are set to be slow and steady, and so any change in asset prices is likely to be gradual, and to take place over an extended period.

It’s been over ten years since the last interest rate rise, so investors will have to dig deep in their memory banks to remember what one looks like. While a rise in interest rates would mark the start of a new era in monetary policy, we don’t anticipate too much disruption in financial markets as the tightening stretch of the cycle looks like it will be long and shallow.

Investors

Interest rate rises are widely expected so it’s really any shift in the anticipated timetable for tighter policy that will move markets. This is a two way street and the path of interest rate rises can shift further into the distance as well as nearer into the foreground. To that end it will still make sense to hold a diversified portfolio in case things don’t go according to the script. Indeed if an interest rate rise doesn’t materialise tomorrow we could see sterling fall and gilts rally.

However we still think there’s little value in global bond markets as the low yields on offer don’t compensate investors for the risks they are assuming. The prospect of rising interest rates throws this into sharper focus, because tighter policy will put downward pressure on bond prices. Perhaps the most concerning aspect here is the high number of people who are blindly defaulted into bonds within their pension plan just as they are about to retire.

For equity investors the picture doesn’t change too much. Rising interest rates turn the screw but they will only happen if the economy is in good enough shape which would be positive for company earnings. In the scenario of low productivity we face in the UK today both economic growth and the pace of rate rises are likely to be sluggish.

There could be some individual stocks which fare better than others, with the banking sector probably best positioned to take advantage of rising rates. The flip side of this particular coin is that cash savers probably shouldn’t get too excited just yet.

An interest rate rise is a hollow victory for cash savers because it still won’t deliver a level of interest that keeps up with price rises. Tighter monetary policy will also take its time to filter through to cash savers because the banks will delay passing through higher rates to depositors for as long as possible.

Overall we don’t see much reason for investors to make significant changes to their portfolio. The main thing to check is how your pension is invested as you approach retirement, and if it is shifted into bonds, make sure that’s an appropriate strategy for you, and that you’re happy with the risks.

UK bonds

Bond prices are in the front line when it comes to potential damage from tighter monetary policy because they pay a fixed amount of annual interest which looks less attractive as rates rise. Interest rate rises are going to be very slow and steady which means that bond prices will probably deflate gradually. One can’t entirely rule out the possibility of bond bubble suddenly bursting, but it looks like a tail risk.

Pension investors may not know how big their bond exposure is as many are defaulted into bond funds as they approach retirement via insurance company lifestyle strategies with the anticipation that they will sell up and buy an annuity at retirement. Only around 20% of people now do this, thanks to pension freedoms. Around £11bn is held in these lifestyle funds on behalf of pension investors.

Tips for investors:

  • Review the portion of your portfolio invested in bonds which may well have got out of kilter thanks to the tremendous run bonds have been on.
  • These fixed interest securities can still provide useful portfolio diversification – after all we may not get an interest rate rise.
  • If you are approaching retirement check if you have been defaulted into an annuity protector fund by your pension provider’s lifestyling process. If you aren’t going to buy an annuity this is an inappropriate strategy and could be heavily exposing your pension to bond market risk at an inopportune time.
  • Where you hold fixed interest investments consider holding them in strategic bond funds, which give the manager the flexibility to invest across the bond spectrum to seek opportunities, and also to protect investors if there is a sell-off.

Cash

Rising interest rates should be good for cash savers though it’s hard to see much of a material impact for income seekers anytime soon. Looking back to rates prior to the referendum as a guide, an interest rate rise back up to 0.5% would see the typical rate on a cash ISA rise from 0.8% to 1.3%.

While that is a significant jump in relative terms, getting £13 annual interest on each £1,000 saved compared to £8 is unlikely to see consumers rushing to fill their boots. Rates on cash accounts probably won’t rise as quickly as they fell either; banks tend to make more profits when interest rates rise because they don’t pass on hikes as quickly to savers as they do to borrowers. All in all, a rate rise is a somewhat hollow victory for cash savers.

Tips for investors:

  • Keep a cash buffer as a rainy day fund – around 3-6 months expenditure as a minimum – but for longer term money consider investing in more productive assets, albeit these come with more risk to capital.
  • Shop around for the best cash rates to make sure your money is working as hard as possible for you.

Property

Residential property – an interest rate rise will lead to an increase in mortgage costs which should constrain house price growth. However a 0.25% interest rise alone doesn’t look sufficient to fully offset the two big tailwinds putting upwards pressure on house prices, namely a big supply/demand imbalance and the Help to Buy scheme.

Commercial property – in theory an interest rate rise is a sign of confidence in economic growth which should be beneficial for commercial property; however while the UK economy is growing its progress is slow. Rising interest rates do make commercial property yields less attractive in relative terms. However, again a 0.25% rate rise isn’t exactly going to lure many investors into cash so we wouldn’t expect a mass exodus from the sector, though there may be a steady drip away if bond yields start to pick up significantly as many have invested in these funds for yield and diversification in lieu of bonds.

Tips for investors:

  • Those who invest in commercial property funds should make sure they are happy with the relatively high costs involved, and are happy to hold for the long term, particularly if invested in an open-ended fund which may suspend dealing in times of distress.
  • Buy to let investors should be wary of the localised nature of the property market, the costs of buying and maintaining a property, and the additional taxation that has recently been added to this kind of investment.

Gold

Rising interest rates are a headwind for gold though global interest rates, and particularly the US, are more relevant than purely the UK. Gold doesn’t yield anything and so if cash and bonds start paying more interest, gold starts to look less attractive by comparison.

Tips for investors:

  • Gold is basically a bit of catastrophe insurance for your portfolio, and so shouldn’t make up more than 5-10%.
  • If investing in ETFs, investors should seek out those which are physically-backed.
  • Gold isn’t a one way bet and can be volatile.

Sterling

The prospects for sterling are not as clear cut as one might imagine and the Brexit negotiations clearly have a big role to play in the longer term fortunes. Rising UK rates are in theory supportive of the pound but progress for the currency may be thwarted by two factors. Firstly, an interest rate rise has already been priced in to some extent, and actually there is a risk sterling falls if a rate rise fails to materialise tomorrow.

Secondly, the UK is not alone in tightening policy. The US has already raised interest rates four times from the emergency rate post-financial crisis and has started to unwind QE. Meanwhile Europe has recently announced a reduction in its quantitative easing policy, which should ultimately pave the way to its termination and the possibility of rising rates. So there is support for the dollar and the euro too, which may constrain the pound’s appreciation if UK rates do start to rise.

Tips for investors

  • We don’t see a great deal of value in trying to adjust your portfolio to take advantage of currency movements which are by their nature unpredictable.
  • Keeping a globally diversified portfolio is one way to get a spread of currencies in your portfolio, however even an investment in the UK stock market comes with a high level of earnings in overseas currencies.

UK Equities

The UK stock market has diversified global earnings streams so at an aggregate level we don’t foresee a great deal of disruption for rising interest rates here in the UK, particularly given how muted and slow these increases are likely to be.

If we get a big rise in sterling this may knock some of the shine off the stock market, but for the reasons stated above a rate rise in and of itself doesn’t mean the pound is going to strengthen significantly. Some hawkish rhetoric from the MPC suggesting a sharper tightening of policy going forward might do the trick, but this seems less likely.

 

Please remember, no news or research item is a recommendation or advice to buy. Every Investor is not responsible for accuracy and may not share the author’s views. If you are unsure of the suitability of any investment for your circumstances please contact an adviser. All investments can fall as well as rise in value so you could get back less than you invest and tax policies may change.

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