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When interest rates start to go up, equities have a habit of re-rating in line with the impact on a particular stocks future earnings. Are investors willing to pay a premium for high growth stocks if their return on cash is starting to rise? Not always when inflation is running high and creating a negative return on cash, even in a higher rate environment. Therefore, not only is the speed and size of rate rises important, so too is the future path of inflation. Throw in the news that central banks are not only stopping their current debt fuelled funding, but they are actually considering reducing their debt (and therefore reducing market liquidity), then you have some issues to think about.
The good news for investors is that throughout tightening cycles, returns tend to be positive. Research from Axa shows that equity markets have gone up during the period between the trough and the peak in the US Federal Reserve Funds rate in every cycle since the early 1970s, except for in 1973-74 when the global economy was hit by the oil crisis. The dynamics are usually that ratings come down (valuation adjustment) but earnings recover through the cycle to allow total equity performance to be positive. We are currently watching the earnings season with interest, and apart from a big miss from Meta (the owners of Facebook), earnings are surprising once again on the upside.
Of course, not all cycles are the same. Typically, the biggest drawdown relative to market levels at the time of the first hike come quite quickly as we saw in January – after all that is when central banks are at their most hawkish. However, when cycles are long and provoke an aggressive slowdown in economic growth prospects, equity market performance can weaken again. That was the case in 2015-2018 when the combination of higher US rates and trade concerns hit markets.
In the early stages of a rate rising environment, you would therefore expect the most expensive areas of the market to be hit hardest and this was certainly the case in US equities and technology stocks in January. We have been favouring the “cheaper” areas of the market and these are – arguably – least at risk from a global de-rating. Top of the list is Asia (mainly China), but also the UK and Japan look attractive.
I fear we may not have spent enough time writing about matters closer to home in recent weeks, with our updates being dominated by the Federal Reserve and Russia vs Ukraine vs Nato. Oh dear, where to start. This week the Bank of England picked the perfect day to raise rates, straight after an earlier announcement on the rise in the UK energy price cap that could raise energy bills by up to 50%. National insurance contributions are also set to go up in April adding to the squeeze on household incomes. If there were a general election in the UK anytime soon, we would all have to start incorporating the Labour Party’s economic policies into the outlook as the Tory faithful continue to jump ship with Boris Johnson’s “credibility” as Prime Minister unravelling quickly. I think I might turn my focus back to foreign shores quite soon.
In the absence of holding cash, which is never sensible in an inflationary environment, we continue to focus our portfolios on areas where downside risk is less. On the equity side the de-rating risk is lowest in markets like the UK, Europe and Japan relative to the US. Markets will get used to the tightening regime at some point, as they always do. Through most cycles, both bonds and equities deliver positive returns. But volatility will be higher. The medium term view i.e. looking into 2023, depends on what happens to growth expectations and corporate earnings. For now, gentle interest rate rises should not be enough to force markets lower for longer, but there will definitely be some winners and losers along the way. Short-term, a peak in inflation in Q1 is imperative as is some rolling over of energy prices. We are keeping a close eye on things for you.