On the rise

Is the era of super-cheap money finally drawing to a close? On 16 December, the Bank of England’s Monetary Policy Committee will announce the outcome of its final monthly meeting of the year – and it now looks almost certain that it will raise interest rates from their current historic low level of 0.1%. Not by much – the likely hike is to 0.25% – but this will nonetheless be a turning point.

Other central banks have already begun tightening their policies. South Korea, Brazil, Norway and New Zealand have all increased the cost of borrowing since the summer. Poland has done so twice, with its interest rates now 1.15 percentage points higher than they were just three months ago.

We may, in other words, be on the verge of a new era. And if interest rates begin to move back to levels that are more normal by historical comparisons, what might that mean for investors?

Well, some asset classes and sectors of the stock market traditionally fare better than others in a rising interest rate environment.

On the former, the obvious loser from rising interest rates is the fixed-income market – because a fixed level of income looks less attractive as the income available elsewhere begins to rise. As for the latter, now may be the time for investors and advisers to think about rotating their portfolios.

On the downside, higher interest rates tend to be bad news for “long duration” equities – those where the valuation of the share depends disproportionately on the company’s earnings over the long term. Analyst value those future earnings by discounting them against bond yields, which rise as bond values fall; higher interest rates therefore equate to lower valuations for these stocks, found in sectors such as technology and pharmaceuticals.

Defensive sectors of the market – think utilities, energy companies and tobacco, for example – also tend to struggle in this environment. Higher interest rates tend to be associated with higher inflation, and this type of business often finds it difficult to raise its prices at the same pace. Their real earnings therefore fall in value.

More positively, financials – particularly banks – are often the big winners from rising interest rates. They make their money by lending cash out at a higher rate than they pay on deposits and as rates rise, there is more margin to take a cut from. Also, since central banks usually raise interest rates only when they think the economy and individual companies are strong enough to cope, this part of the economic cycle usually tends to see fewer loan defaults.

The question for investors and their advisers is how to position their portfolios against this backdrop. Helpfully, the investment companies analyst team at Stifel has recently published research on the type of funds that might benefit during an era of rising inflation and interest rates.

For one thing, the investment companies sector offers specialist plays such as Polar Capital Global Financials, Stifel points out, offering investors focused exposure to the financial services sector. Investment companies are also the only route most investors have into alternative investment classes; in particular, the infrastructure sector’s income is often directly linked to inflation, with RPI-linked guarantees underwritten by the state in areas such as renewable power.

Real estate could be another option in this marketplace; again a closed-ended fund is the most appropriate way to secure exposure to this illiquid asset class.

There are no certainties right now. The Covid-19 pandemic continues to cause stock market volatility – and economists are split about whether the current level of inflation is a temporary phenomenon, and therefore requiring only modest rises in interest rates. Still, it does feel as if we are moving into a different economic landscape – and investment companies may be the best way for many investors to navigate that shift.