Is there further pain to come for bonds and growth-focused strategies, such as Scottish Mortgage, if interest rates stay higher for longer than expected?
Will interest rates stay higher for longer than expected? There is growing feeling among economists and asset managers that they just might.
It’s not simply that both the UK and the European Union are finding it tougher than expected to get on top of inflation – the picture in the US, although ostensibly better, is mixed too – but also that policymakers are wary of repeating the mistakes of the past.
Too early to say inflation battle has been won?
Central banks know they have too often declared victory prematurely in the battle against inflation, warned the Bank for International Settlements (BIS) recently. Prices in financial markets suggest the consensus among investors is that interest rates will stop rising this year and then fall sharply in 2024, the BIS said, but that may be unrealistic. “[Central banks have given] no indication that easing is on the horizon,” the BIS warned. “[This] cautious attitude is the right one.”
Sonal Desai, chief investment officer of asset manager Franklin Templeton Fixed Income, shares that view, particularly on the all-important question of the Federal Reserve’s likely moves on US interest rates. Financial markets aren’t even being rational, she points out.
“There is a striking dissonance in financial markets’ pricings,” Desai warns.
She adds: “The prediction of sharp Federal Reserve rate cuts would suggest a deep recession, perhaps precipitated by a credit crunch or a more extensive banking crisis. But risky assets have not sold off commensurately. Any widening in credit spreads has come almost entirely from moves in the underlying risk-free rates. That’s not at all consistent with an economic environment that would force the Federal Reserve into rate cuts.”
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Such a view is not universal. For example, Joseph Quinlan, head of CIO market strategy at Merrill Lynch, argues that while uncertainties persist, the case for expecting an end to rate rises this year, followed by some loosening of monetary policy in 2024, is a reasonable one.
“With both inflation and final demand trending lower, the end of the tightening cycle is approaching,” he says. “We are at the beginning of the end.”
The International Monetary Fund (IMF) has also suggested recently that “increases in real interest rates are likely to be temporary”, albeit recognising that inflation must be dealt with.
Nonetheless, there is plenty of anxiety out there. Even more optimistic analysts such as Quinlan concede that “this path is hardly set in stone”. And others urge caution.
Richard Carter, head of fixed interest research at Quilter Cheviot, warns: “Inflation is proving stickier than feared, with core inflation being particularly stubborn.”
Investors therefore need to be conscious of the implications for markets if higher interest rates do prove to be more enduring.
Bonds to naturally suffer from more rate rises
Indeed, in the bond market, which is particularly sensitive to interest rate moves and sentiment, the effects of uncertainty are already being felt. The Ice BofA Move index – an important gauge of bond market volatility – now stands at levels not seen since the global financial crisis.
The big picture is that when interest rates rise, so too do bond yields, since investors are not prepared to hold assets that don’t look competitive with cash deposits. That means bond prices fall – hence the remarkable sell-off in global bond markets over the past two years.
In practice, however, the effect is more nuanced. Some bonds are more sensitive than others to interest rate movements; long-duration assets – not due to be repaid until the long term – are affected more significantly, as are bonds issued by borrowers considered more risky.
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In this context, a recent briefing by Tiffany Wilding and Andrew Balls, economists at Pimco, the world’s biggest bond fund manager, concluded: “We prefer higher-quality, more liquid investments and are avoiding lower-quality, more economically sensitive areas, such as lower-rated floating-rate corporate credit, that are most exposed to the effects of tighter monetary policy.”
In the real estate sector, meanwhile, higher interest rates also tend to act as a headwind because the increased cost of borrowing dampens demand. There’s the added complication right now of the fall-out from the collapse of Silicon Valley Bank; that crisis is likely to make lenders more cautious about providing financing – it could even trigger tougher rules from regulators.
In the UK, the real estate market is already in the doldrums, points out Simon Rubinsohn, chief economist at RICS. “A more cautious approach from lenders is still likely to weigh on investment volumes,” he warns. “Activity continues to bump along the bottom.” Indeed, recent data from Savills show transactions running at £3 billion in the first two months of 2023 – around 50% of the average over the past decade.
Interest rate expectation shift could cause more pain for growth stocks
And then there’s the equity market. So far, 2023 has seen global stock markets largely tread water, albeit with some modest gains in certain cases. Even growth stocks such as the technology companies have stabilised – for the most part – after a disastrous year in 2022.
However, a shift in perceptions about the direction of interest rates has the potential to change the dynamic once. As rates rose over 2021, growth investing fell out of fashion in favour of more value-oriented styles. When inflation and interest rates are higher, investors set less store in the value of future earnings – which is what growth companies promise – than they do cash today. If “higher for longer” does become the consensus view, growth stocks may therefore suffer further.
“There is a perception that these are abnormally high rates, but they are only abnormal in the context of the decade of quantitative easing that followed the global financial crisis,” warns James Henderson, co-manager of Henderson Opportunities (LSE:HOT) and Lowland (LSE:LWI).
He adds: “The best way to protect capital is through equities and, for me, that means investing in good companies that are generating revenues already – which does not preclude all adventurous businesses, but does rule out many.”
It's a message echoed by Dzmitry Lipski, interactive investor’s head of funds research. He says: “Growth as a style has really struggled over the last year. Investors should ensure their portfolios are well diversified and balanced without a strong bias to any one style or market cap in order to control risk and help limit losses within your portfolio."
Macro backdrop a headwind for Scottish Mortgage
Naturally, such warnings apply doubly to the most adventurous growth strategies – such as the approach of Scottish Mortgage Ord (LSE:SMT), the investment trust that delivered stellar outperformance for so long but has more recently struggled. While its investors will hope the worst of its travails are now over, some investment trust analysts are not convinced this is the case.
“The unsupportive macro backdrop brings strong headwinds for Scottish Mortgage’s ‘growth at unreasonable prices’ philosophy,” warns Alan Brierley, an investment trust analyst at Investec, who is maintaining his sell recommendation on the investment trust.
He adds: “Looking longer term, we cannot see how a return to what was the most supportive of macro environments for Scottish Mortgage can be engineered.”
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This is not to suggest investors should steer clear of all equities – or even all growth stocks. Higher interest rates generally are not good news for corporates, since they increase their costs and reduce their propensity to borrow money to invest. But there will still be opportunities amid the gloom, insists Alex Stanić, head of global equities at Artemis and co-manager of the Mid Wynd International Investment Trust (LSE:MWY) and the Artemis Global Select Fund.
“Success or failure for long-term investors should not be dependent on their ability to anticipate such business cycles and central bank decisions, says Stanić. “They need to invest in quality businesses that are immune to these fast moving and unpredictable tides.”
His tip is to focus on “secular growth” – market themes that defy short-term market dynamics, such as “automation, the sustainable consumer, online services, lower carbon world and healthcare costs”.
On that basis, Stanić argues: “Investors who choose well-managed, profitable businesses operating in areas of resilient growth and who buy these companies at a reasonable price, should be able to thrive over the long term whether inflation is strong or weak, and whether interest rates are up or down.”
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