Rates set to rise but no need to panic
Central banks look set to increase to cost of borrowing but history shows we have no reason to fear any short-term volatility, argues Jonathan Sloan, private banker with Barclays Wealth NI
Inflation has been much in the news of late, with UK consumer price inflation persistently above its target level. The rise in the VAT rate at the start of the year has been one factor behind this; high oil prices another.
The Bank of England’s Monetary Policy Committee (MPC) also now reckons that spare capacity in the British economy is less than originally estimated, and that persistent current high rates of inflation might therefore pass through more directly to wages and prices.
We think that the MPC will be keeping a close eye on commodity prices, inflation expectations, wages and the robustness of future demand in order to gauge exactly when and by how much policy needs to be tightened.
In the current fiscal and oil-price environment, and with the additional uncertainty generated by the terrible disaster in Japan, the momentum behind growth is far from certain. Even so, we still think that the Bank of England is likely to raise rates by 0.25% in May.
With the European Central Bank also preparing the ground for a rise in interest rates (by 0.25%, we reckon, and probably this month), we can expect a long and heated debate among economists about whether they are right or wrong to be doing so.
But from an investor’s point of view, the most important thing is not what should happen, but rather what will happen. Some volatility in equities is quite likely as the debate over rates rages, and some economic data point to a levelling-off and moderation in economic growth. But as long as growth remains firmly positive, quoted sector corporate profits will continue to rise well ahead of nominal GDP in most countries, and prospective equity valuations will, in our view, remain attractive.
History suggests that the first moves on interest rates are rarely accompanied by a reversal in broad market trends — neither in the last two cycles in the euro area, nor in the German market under the more hawkish Bundesbank previously, nor of course in the US over a longer time period. Rather, the peak in stock prices usually comes many months (usually years) later, when valuations and economic prospects have deteriorated markedly.
The rationale for the failure of stock markets to turn tail the instant that interest rates begin to rise is that, more often than not, rising interest rates go hand-in-hand with a strong economy, not a weak one. And this time around, when the Fed in particular eventually gets around to “snugging” rates higher, it may be interpreted as official confirmation that the massive US economy is at last out of intensive care.
So, in the case of developed economy stocks currently, we continue to see further headroom in 2011, despite the greater proximity of rising interest rates and the potential for short-term volatility it brings.
Fixed-income investments face a more ambiguous future, for obvious reasons. The end of the 30-year bull market in bonds may be at hand, but that does not mean that we face an immediate and severe bear market.
A small overweight position in high-quality long-dated government bonds may still be useful as portfolio insurance. We know they are not cheap, and that rising short rates could trigger a resumed rise in long yields, but in a balanced portfolio, which includes bigger-than-usual weightings in risk assets, the insurance may be useful.
For cash itself, the investment case in our view is still clear-cut. Even though rates may be rising a little faster than we’d previously assumed, it will still be many months before they rise to levels that make money market deposits look attractive relative to other asset classes in the economic climate that we envisage.
And the world still does not look dangerous enough to warrant sheltering in this safe haven.