Prepare for rising interest rates

What to do with your investments
Thursday 12 Oct 2017 Author: Steven Frazer

UK interest rates have to rise at some point and it seems we are fast approaching that day. Market commentators now believe the first rate increase in a decade could happen at the next meeting of the Bank of England’s Monetary Policy Committee, scheduled for 2 November.

Governor of the Bank of England, Mark Carney, has recently given the biggest indication yet that the UK base rates will increase in the very near future.

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‘If the economy continues on the track that it’s been on, and all indications are that it is, in the relatively near term we can expect that interest rates would increase somewhat,’ Carney told BBC radio in late September.

His more hawkish comments on a near-term rate increase caught the market by surprise. Most economists were not anticipating a rate rise until well into 2018.

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What does a rate rise mean for savers?

For cash savers, rising interest rates will come as a relief as it holds out the prospect of finally being able to get a better return on cash deposits than seen for many years.

Interest rates have been low and generally less than the rate of inflation since 2008, thus the real value of the money on deposit has been eroded.

Although hiking interest rates should help savers, they still need to be vigilant as savings providers may not increase rates by as much as hoped. We’re also unlikely to see interest rates quickly increase by a large amount once they do start to move up.

Research from independent savings advice website Savings Champion shows five years ago, when the base rate was 0.5%, the average easy access account was paying 0.74%. Today that average rate has fallen to 0.35% and the Bank of England’s official rate sits at 0.25%.

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Is a rate rise good or bad for investors?

Many investors presume that rising interest rates are bad news for stock markets yet this is not necessarily the case, according to data provided by trading company Salt Invest.

Its analysts looked at the performance of the FTSE 100 index and the more domestically-orientated FTSE 250 index during the last three periods of rising UK base rates. The results show that both the large and mid-cap indices continued to rise in value or held firm against the backdrop of rising interest rates.

‘Escalating base rates may mean that interest paid on deposit accounts increases and so the returns on quoted companies may become increasingly less attractive,’ says Salt. That latter comment looks a bit extreme when you consider that interest rates aren’t expected to jump back to the 5%+ territory to which many of us were accustomed a decade ago.

Theoretically better rates on lower risk assets, such as long-term savings products, eat into the relative attractiveness of higher risk equities. However, we cannot see a scenario in the near future where cash will provide a better return than the 5-6% you’ve historically been able make from the stock market each year. As such, we don’t believe investors will rush to dump their stocks as soon as rates rise.

main7Nonetheless, we do believe that investors will rejig their portfolios as there are obvious winners and losers from rising interest rates. We’ll discuss some of the sectors like banking and housebuilding later in this article.

‘In the past, base rate rises seem to have been generally positive for the UK market,’ admit analysts at Salt. ‘Inflation normally goes up when the demand for goods and services rises more rapidly than an economy’s productive capacity.

‘Base rates are applied as a brake to allow for measured and sustainable economic growth; something that’s illustrated by the performance of many stocks.’

A glance across the pond is worthwhile. US interest rates started rising in December 2015, the first hike in almost 10 years.

‘Despite a number of rate rises in the US, it hasn’t stopped the Dow Jones Industrial Average climbing 28% over the same period,’ the investment experts point out, ‘or the S&P 500 rallying 25% to current record highs of around 2,545.’

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What about bonds?

Changes in interest rates will affect the value of bonds in your portfolio. If rates are rising, newly issued bonds with higher rates on the market will be more appealing than older bonds in your portfolio paying less. This situation can reduce demand for your existing bonds and push down their resale value.

When rates are rising, short duration bonds could be more appealing than ones with longer maturities as the latter tend to suffer most because they lock investors into lower rates for extended periods.main6

What about your own personal finances?

Rising repayments on your home is a big consideration if you have a tracker mortgage. Repaying a mortgage is the biggest monthly outgoing for many people.

While the mooted move from a 0.25% base rate to 0.5% is unlikely to put a big squeeze on monthly household budgets, a sustained rising trend could have an impact.

Three or four rate rises over the next couple of years – which is not out of the question – would likely mean substantial household belt-tightening.

According to the Bank of England, 43% of homeowners are on variable or tracker rates.

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On the average mortgage of £125,000, an increase of 0.25% would increase monthly payments by £15 to £665. That would amount to an extra £185 per year, according to Nationwide’s data.

But while the impact of the first hike may be small, someone with a mortgage of £150,000 could find themselves paying an additional £161 a month if rates increased by 2%, according to figures supplied by the Halifax, Britain’s largest lender.

Companies will also face the same test with regards to corporate debt repayments.

What does the current economic data suggest?

Alan Haldane, the Bank of England’s chief economist, has been at pains to highlight the positives of a rate rise.

Such an event would be a sign of the economy healing, and therefore adjusting to that healing process. ‘So rather than being a source of fear or trepidation, this ought to be a good news story about the economy proving resilient,’ he recently told Sky News.

Although the Bank of England has highlighted ‘pockets of risk’ among consumer debt, macro data seems supportive of rate rises, not least the inflation figure which is currently above the Bank of England’s 2% target.

‘Inflation and unemployment figures might suggest a rate rise in merited, but flaccid wage growth does not,’ says Russ Mould, investment director at investment platform AJ Bell.

‘Wage increases continue to run below inflation and this apparent break down in the Phillips Curve, which asserts low unemployment should lead to higher wage increases (and vice-versa), does still seem to be a major factor in Bank of England thinking,’ he adds.

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Expert opinions are split

Samuel Tombs at Pantheon Macroeconomics says the UK services sector remains ‘stuck in a rut,’ casting doubt over whether the Monetary Policy Committee will press ahead with a rate rise over the coming months.

‘The latest PMIs (purchasing managers’ index data) – especially the decline in their forward-looking balances – do not warrant such optimism,’ he adds.

Economic experts at Russell Investments go further, claiming an interest rate rise this year against a backdrop of weak underlying growth would be ‘a mistake’.

‘If the Bank of England chooses to hike rates this year, we expect the underlying growth slowdown to take centre stage again, especially when inflation starts to roll over,’ says Russell’s senior investment strategist Wouter Sturkenboom.

A cooling in the housing market, mixed industrial sentiment surveys and the debate over what Brexit may or may not mean for the UK’s economic prospects are additional complications.

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STOCKS:  Possible rate rise winners

Rising interest rates are considered to be positive for the domestic currency so you could assume that sterling will strengthen near-term.

In general, the higher rates that can be earned tend to attract foreign investment, increasing demand for the home country’s currency.

Such a situation implies a negative outlook for the FTSE 100 which has a high proportion of overseas earners. They benefit from weak sterling as they get a translational benefit when reporting foreign earnings in sterling. So a strong sterling has the opposite effect and could trigger analysts to downgrade earnings forecasts.

The biggest beneficiaries from rising UK base rates are likely to be the big importers and the UK-dominant banks. It should be good news for retailers which source a lot of products from overseas, although they face the risk that consumers have less spare cash to spend in the shops if their credit card, loan and mortgage repayments are pushed up.

Retailers which buy goods from overseas include Next (NXT) and Primark-owner Associated British Foods (ABF). The cost of products, in sterling terms, will be reduced which should allow for higher margins and increased earnings.

We’re more cautious on over-spaced, structurally-challenged shopkeepers. Operators such as Debenhams (DEB) are best avoided from an investment perspective, in our view, while near-term prospects suggest investors should steer clear of Dixons Carphone (DC.) and DFS (DFS).

They sell higher-ticket items like mobile phones, laptops and sofas whose purchase could easily be delayed by consumers under financial pressure from higher cost of servicing debts.

Which banks look good?

Banks and other financial stocks tend to enjoy fatter profit margins in rising interest rate environments which also serve to provide a lift to earnings and ultimately their share price.

In theory, that should play well for all of the major high street lenders including Barclays (BARC), HSBC (HSBA), Lloyds (LLOY), Royal Bank of Scotland (RBS), along with smaller challenger banks. These include Aldermore (ALD), Metro Bank (MTRO), OneSavings Bank (OSB) and Virgin Money (VM.).

Rising base rates will allow the banks to charge borrowers higher rates while probably only paying a little more to savers.

At the moment we’re big fans of Virgin Money as an investment as its shares trade on a low valuation and it has considerable growth prospects. We believe it is capable of stealing a much larger market share than its current 3% or so of the UK mortgage market.

We’re more cautious on Lloyds following the recent acquisition of credit card company MBNA. In our view, this increases its exposure to unsecured lending which raises the risk that the bank’s capital buffers could be damaged if there is an economic downturn.

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STOCKS:  Possible rate rise losers

A rising interest rate is bad for companies with high debt levels, particularly those which have to refinance their debts in the near future as they could incur higher repayment costs.

Consumer-related property companies also look vulnerable, in our view. Rising mortgage rates (off the back of rising interest rates) could make it harder for some people to get on the property ladder, thus sentiment could wane towards housebuilders, in particular.

Since the Brexit vote, shares of housebuilders like Barratt Developments (BDEV), Berkeley Group (BKG), Bovis Homes (BVS), Persimmon (PSON) and Taylor Wimpey (TW.) have enjoyed a good run. Now could be a good time to reduce exposure to the sector.

‘The housebuilders are sitting ducks, as the housing market is in for a shock when rates finally begin to rise again,’ say Salt’s market experts. ‘It does look as though the current year will see earnings peak for the housebuilders, as they get hit by the double whammy of house price inflation cooling off and building costs rising.’

At the moment we like MJ Gleeson (GLE) in the housebuilding space as its premium valuation is justified by exposure to a resilient affordable housing niche in the north of England. We also favour Telford Homes (TEF:AIM) whose focus on relatively affordable homes in London should protect its own growth prospects.

A strong run for larger housebuilder Berkeley has left it looking particularly vulnerable to any slowdown in its high end London market.

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The Shares team
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