What is the impact of rising interest rates?

After a long period of rock-bottom interest rates, interest rates are finally rising.

In August, the Bank of England lifted interest rates to 0.75%, the highest base rate since early 2009, while in the US, the Federal Reserve has increased interest rates three times already in 2018, with the target rate now set between 2.00% and 2.25%.

In our last two articles, we have looked at why interest rates are now rising and examined the outlook for interest rates going forward. In this article, we will look at how higher interest rates may impact other asset classes and what higher rates mean for UK savers and investors.

Good news for cash savers

For cash savers, higher interest rates are a positive development.

Savers are likely to see higher interest rates offered on products such as Cash ISAs, easy-access savings accounts, and fixed-term savings deposits and that means that they will be able to generate higher levels of interest on their savings.

That said, with inflation remaining above 2% in the UK, it is likely to take many more base-rate increases for UK banks to offer interest rates that are attractive in ‘real’ terms (i.e. after adjusting for inflation). Therefore, savers need to be aware that cash savings products may not protect them from the wealth-destroying effects of inflation.

Bonds may underperform

Bonds are often viewed as ‘safe’ assets, however, it’s important for investors to understand that bond prices have an inverse relationship to interest rate movements. In other words, when interest rates rise, bond prices fall, and vice versa.

This occurs because bond coupon payments are generally ‘fixed’, so when interest rates rise and higher yields become available in the market, fixed coupon payments lose their value.

Bonds performed well when interest rates fell a decade ago, as their fixed coupon payments became more valuable. Yet now that interest rates are moving upward, the asset class looks set for a period of underperformance, and therefore has significantly less appeal. Longer-term bonds are particularly vulnerable in a rising-interest rate environment. 

Mixed outlook for equities

With interest rates rising, the outlook for equities is mixed. Some areas of the equity market, such as smaller growth companies, should continue to perform well, as the economic conditions that lead to higher interest rates (low unemployment, strong wage growth, higher consumer spending) are generally good for business growth. However, there are also specific areas of the equity market that could potentially underperform as interest rates continue to rise.

One particular group of stocks that looks vulnerable is the ‘bond proxies.’ These are dividend stocks in sectors such as consumer goods and utilities that pay investors regular bond-coupon-like dividends. When interest rates were close to zero and bond yields were negligible, the dividend yields on offer from the bond-proxies made these stocks highly attractive investments. However, now that interest rates are rising and it’s possible to pick up higher interest rates risk-free, investors may be willing to pay less for the shares. 

Other stocks that warrant caution are those with high debt levels. For companies that are leveraged, higher interest rates translate to higher borrowing costs, and even a modest rise in interest rates can make debt-laden companies more vulnerable. Therefore, investors should be wary of companies that have over-borrowed. 

Uncertainty for residential property

Turning to residential / buy-to-let property, the outlook for this asset class looks uncertain in a rising interest-rate environment.

As a result of higher base rates and the withdrawal of the Term Funding Scheme – which was designed to keep rates low in the real economy – mortgage rates within the UK are likely to rise going forward. As a result, both residential property prices and buy-to-let property prices could stagnate in the short term, limiting capital gains.

With interest rates moving higher, investors need to be selective about property investments in the years ahead.

Real assets should outperform

One asset class that does have the potential to outperform in a rising interest-rate environment is real assets.

Real assets are physical assets such as real estate, infrastructure and commodities, that have value due to their tangible properties. The performance of real assets is often linked to macroeconomic drivers and global economic growth trends.

Specific examples of real assets that look set to perform well in the years ahead include real estate investment trusts (REITs) associated with retirement villages and care homes, which should benefit as the UK’s population continues to age, and REITs focussed on warehouse storage facilities, which should benefit due to the increase in popularity of online shopping and the subsequent demand for storage warehouses from companies such as Amazon, Argos and B&Q. REITs that specialise in these kinds of real assets often offer robust yields, and can also hold up quite well during economic downturns.    

Gold is another real asset that could outperform in the years ahead, as investors often turn to the precious metal when inflation is rising, causing its price to increase.  

The final word

Rising interest rates are likely to have implications for all asset classes.

And it’s important for savers and investors to understand that even if UK interest rates are not increased in the short term due to Brexit uncertainty, those in the UK are still likely to be affected by higher rates internationally. Already, we have seen volatility return to global equity markets in recent months as a result of concerns over higher interest rates in the US.

At Featherstone Partners, our focus is on absolute-return investment strategies, which aim to generate positive returns no matter what global financial markets are doing.

In the current environment, we are focusing on assets that have the potential to outperform as interest rates continue to rise and appreciate above the rate of inflation. At the same time, we are constructing our portfolios so that they have minimal exposure to assets that are vulnerable in a rising-interest rate environment.

Leveraging significant industry experience, our team identifies and carries out due diligence on some of the world’s most specialised funds, in order to provide our clients with access to world-class, niche investments that few private clients typically have exposure to. We believe that through an absolute-return approach, we can continue to generate steady, positive returns for our investors, regardless of interest rate movements.

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