Equity and bond markets have thrived on low interest rates and quantitative easing, but they can’t last forever. At some point rates will have to go up to combat inflation – but when?
This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Ben Yearsley discusses the interest rate conundrum.
I have believed for some time that we are in an extended era of low interest rates. Despite the comments of the Governor of the Bank of England, Mark Carney, last week that recovery in the UK is taking hold, and that unemployment could fall below its 7% target by the end of next year, I believe he will remain cautious about putting up rates too soon. To do so would increase borrowing costs for businesses and home owners and potentially jeopardise what is so far a fragile recovery. It still looks likely that rates will remain on hold until after the 2015 general election.
It’s a similar story in the US. Markets have been buoyed by the nomination of Janet Yellen to be the next Chairman of the US Federal Reserve. Ms Yellen has often been seen as ‘dovish’ and, true to form, she has signalled that she will support the unprecedented quantitative easing stimulus further. Like the UK, the US has seen inflation fall and growth pick up, reducing the pressure to tighten monetary policy. As for Europe, last week’s cut in the European Central Bank’s main policy rate from 0.5% to 0.25% clearly shows that deflation (falling prices) is the prime concern.
Against this backdrop it is hard to see where the pressure on authorities to raise rates will come from in the near term. All we know is that the day will come – eventually – but by the time it happens markets will have anticipated it, possibly months in advance. In an environment of rising rates, gilts and bonds are vulnerable. They pay a fixed level of income, and in order that their yield provides investors with a fair return compared to interest rates, capital values must fall as interest rates rise.
This is why many bond fund managers we speak to hold shorter dated bonds maturing (and repaying investors’ capital) in less than five years. These are less sensitive to interest rate movements, and offer a more predictable return. High yield bonds should in theory also be less sensitive. They rely more on the general economic outlook and company credit-worthiness, though in the short term it is likely all bonds will be hit to some degree if rates rise. So the message with bonds is tread carefully. You may receive a perfectly satisfactory return, but this asset class will always be vulnerable to a shock rise in inflation or interest rates.
Equities tend to fare reasonably well during periods of mild inflation and interest rate increases, though you have to wonder what would happen if there was an unexpected rise today. It would seem that a benign scenario of low rates coupled with QE is factored into prices as they stand – even talk of ‘tapering’ in the US is enough to send shockwaves through the markets. As ever, investing means taking risk, but I think a good strategy is to seek equities that could increase their earnings or dividend pay outs – either in funds or individual shares depending on your preference. As rates rise, probably to combat inflation, investors will prize investments that have the potential to compound growing income streams.
Some investments in this camp include Finsbury Growth & Income (FGT) managed by Nick Train, a long term investor who tends to run very concentrated lists of holdings, and Murray International (MYI), which has an excellent past record of dividend growth, though past performance is not an indication of future results.
I believe Legg Mason US Equity Income [Rated 
Bronze) is also worth considering. Dividend pay out ratios in the US are low compared to the UK, which means more scope for increases over the next decade – even if profits only rise marginally. The managers would rather target lower paying companies today that have the chance of increasing pay outs substantially over the coming years. In the UK, Threadneedle UK Equity Alpha Income [Rated Bronze] is also worth a look. Manager Leigh Harrison is expecting about 4% dividend growth this year, and is moving the portfolio in to areas he thinks will deliver more growth going forward.
