What's Going On With Interest Rates?
In recent weeks, we’ve seen a lot of movement from central banks on their monetary policy, which is significant for global markets. The Reserve Bank of Australia increased its cash rate for the first time since 2010. A couple of days later, the Federal Reserve announced an extra-large hike of 50 basis points. Finally, the Bank of England returned its base rate to the highest level since 2009. Bond yields followed higher, with ten-year treasuries breaching three percent, while UK equivalent gilts similarly pushed through two per cent. The ECB is not expected to lift rates before July; however, Eurozone ten-year yields rose by almost the same proportion. This has led to many economists predicting the end of the era of ‘lower forever’ yields. The global value of negative-yielding bonds is rapidly shrinking (see chart below).
Negative Yielding Bonds
Source: Bloomberg (May 2022)
Why are interest rates going up?
Interest rates are rising for one simple reason: inflation. We’ve written about inflation recently, detailing what it is, what causes it, and how to protect against it. Since then, inflation has spiked to multi-decade highs and is beginning to have a profound effect on all our lives. It is no wonder then, that controlling inflation is now a hot topic, but how can it be done?
Generally, there are two ways to control/bring down inflation. Monetary policy (money supply and interest rates) is the more commonly used method, leaving central banks to deal with inflation independently of governments, which tend to be more short-term in their thinking and politically motivated. Alternatively, fiscal policy (government spending/borrowing/taxes) can be used, but this is not preferred to monetary policy.
So, with this in mind, it is no surprise to see central banks beginning (finally) to react to elevated inflation – that is, inflation above target (2% usually) – by raising interest rates. Increasing rates is one way of stemming demand in the economy, and thus potentially lowering prices. It is doubtful that this will have much effect in the immediate term, however, because much of the inflation in the system at present comes from supply side constraints brought about by covid-19 economic lockdowns, which saw factories and supply chains around the world grind to a halt. Unsurprisingly, global supply is struggling to catchup with the very sudden recovery in demand following the easing of restrictions.
The bigger picture
As written earlier, the Federal Reserve has begun raising its base rate in an attempt to combat ever-increasing levels of inflation, which in the US recently hit 8.5%. Looking at the context, whilst rates are increasing, they are still extremely low by historic standards. We are still, it seems, in the very early stages of a rate hiking cycle.
Fed Interest Rates
Source: Bloomberg (May 2022)
Looking further, we can see the extraordinary amount by which the Federal Reserve balance sheet has expanded over the past two decades – the same is true of every major central bank – and it is quite telling. With interest rates rising and central banks beginning to move to quantitative tightening, the money supply has a long way to come down before getting back towards more ‘normal’ levels. The huge increase during the coronavirus crisis was historic and must, at some stage, be unwound.
Federal Reserve Balance Sheet
Source: Bloomberg (May 2022)
What does it all mean?
Market dynamics are shifting before us all; what worked well in the years following the financial crisis will not continue to outperform in the face of shifting macroeconomic conditions such as we are seeing at present. Growth stocks in particular are vulnerable, and we have already seen significant price reversions in some of the largest and most popular growth stocks that were the largest beneficiaries of the trading conditions over the past years. Record low interest rates, near-zero inflation, ever-increasing money supply, high economic growth, these have been the perfect combination of factors for the share prices of high growth companies to thrive. However, with inflation hitting multi-decade highs, interest rates rising, money supply contracting and economic growth beginning to slow, we are entering a new phase of the market cycle.
We can expect stocks that have been unloved and underappreciated to begin to shine (this has already started) with a move away from some of the high-priced growth companies and towards those which show strong earnings and cash flows, stable dividends, and lower share prices (value companies). Bond markets will likely continue to struggle as interest rates rise, though are poised to outperform if the economic picture worsens. Commodities, which have been one of the primary causes of inflation, could well continue even higher, however are susceptible to lower economic growth as well.
What has A&J done?
A&J has made several moves to shore up the portfolios and protect against the changing macro dynamics. We began selling down some of our growth equity holdings, such as Baillie Gifford American which has a lot of technology exposure and began buying value equity funds. Specifically, we liked the value play in the US given it has the biggest dispersion between growth and value in the whole world. We also bought global value exposure to take advantage of the opportunities presented globally.
The investment team also bought commodities exposure with some of the capital freed from exiting our positions in growth funds. Commodities are the best performing asset class so far this year and continue to perform well against both equities and bonds.
We made a considerable effort to lower bond duration and overall exposure, preferring negative duration bonds and cash, believing the fixed income markets to be at risk of devaluation if interest rates were to increase from such low levels. Our strategic bond fund holdings have the flexibility to lower their duration without constraints, as well as increase duration as and when the markets environment improves.
We remain vigilant and will continue to ensure portfolio risk is minimised during periods of heightened market volatility such as this.
The opinions expressed in this update are those of A&J Wealth Management Limited only, as at 9th May 2022, and are subject to change.
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