Movin' on up

14 December 2016

John Carran

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The imminent ascendency of Donald Trump to the most powerful office in the world has coincided with a rapid rise in interest rates in the US and globally. Interest rates were starting to rise before Trump’s election victory, as economies improved and inflation edged up. Anticipation of Trump’s tax cuts and big spending on infrastructure has thrown fuel on the fire, resulting in interest rates rising at a breakneck speed in recent weeks.It’s about time! Interest rates had reached ridiculously low rates earlier this year, as low inflation and gloom set in about the longer-term economic outlook. Central banks have been cutting their policy rates like mad in an attempt to entice people to spend. In some countries, including Germany and Japan, interest rates went negative, meaning that investors had to pay to lend money to governments and safer banks.

However, ultra-low interest rates are not sustainable unless we are heading for a long period of economic stagnation accompanied by deflation. On current trends, we do not consider this scenario likely. Instead, we see moderate growth and inflation ahead, especially now that oil prices have turned up and the US, Europe and China are likely to increase government spending. This means that moderate interest rate rises are justified in coming months.

Rock-bottom borrowing costs no longer needed

Central banks around the world appear to be in the early stages of recognising that rock-bottom borrowing costs are now not needed. The US Federal Reserve has just lifted its cash rate, and many investors are now expecting the European Central Bank and Bank of Japan to start backing off their extraordinarily accommodative policies over the next year to 18 months.

A consequence of ultra-low interest rates has been distortions in financial markets. Anything with an income yield associated with it, such as bonds, high-dividend shares, and property, has been substantially bid up in value. These types of investments are now generally very expensive compared to other parts of markets. They are more vulnerable to rises in interest rates and, indeed, their prices have been hit hard in the past month as interest rates have climbed.

In contrast, some of the parts of the market that have been shunned in recent times, particularly in industries such as financials, materials and industrials, have performed extremely well since interest rates started to climb in earnest in early November. Gains in these areas have generally outweighed losses in more defensive areas so that, in aggregate, share markets are comfortably ahead since the beginning of last month. 

Not all plain sailing

It’s not all plain sailing from here though. Although investors have been relatively sanguine about interest rate rises up to this point, they will start to get nervous if they continue to climb at their recent pace. Rises so far have been predicated on governments delivering on government spending and tax cuts and continuing economic improvements. Any back-tracking will cause investors to reassess whether the recent rises in the values of riskier investments have been justified. And many will be wary of the prospect of inflation again becoming a problem that central banks need to hurriedly raise interest rates to address. 

We have been wary of the prospect of interest rate rises for much of this year, which is why we have maintained relatively low allocations to inaptly named “defensive” shares and longer-maturity fixed interest securities, the prices of which are more sensitive to changes in interest rates. We are always watching for developments and the implications for investments. Shifts in investing environments present risks, which we manage to help protect capital. But, they also present opportunities to get the best returns and add value to portfolios.

This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed, or relied on, as a recommendation to invest in a particular financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any investment decisions.

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John Carran, Senior Economist at Gareth Morgan Investments

You can read more articles by John on the GMI blog

Topics: Economy

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