Pre­pare for ris­ing in­ter­est rates

WHAT TO DO WITH YOUR IN­VEST­MENTS

Shares - - CONTENTS - STEVEN FRAZER

UK in­ter­est rates have to rise at some point and it seems we are fast ap­proach­ing that day. Market com­men­ta­tors now be­lieve the first rate in­crease in a decade could hap­pen at the next meet­ing of the Bank of Eng­land’s Mone­tary Pol­icy Com­mit­tee, sched­uled for 2 Novem­ber.

Gover­nor of the Bank of Eng­land, Mark Car­ney, has re­cently given the big­gest in­di­ca­tion yet that the UK base rates will in­crease in the very near fu­ture.

‘If the econ­omy con­tin­ues on the track that it’s been on, and all in­di­ca­tions are that it is, in the rel­a­tively near term we can ex­pect that in­ter­est rates would in­crease some­what,’ Car­ney told BBC ra­dio in late Septem­ber.

His more hawk­ish com­ments on a near-term rate in­crease caught the market by sur­prise. Most econ­o­mists were not an­tic­i­pat­ing a rate rise un­til well into 2018.

WHAT DOES A RATE RISE MEAN FOR SAVERS?

For cash savers, ris­ing in­ter­est rates will come as a re­lief as it holds out the prospect of fi­nally be­ing able to get a bet­ter re­turn on cash de­posits than seen for many years.

In­ter­est rates have been low and gen­er­ally less than the rate of in­fla­tion since 2008, thus the real value of the money on de­posit has been eroded.

Al­though hik­ing in­ter­est rates should help savers, they still need to be vig­i­lant as sav­ings providers may not in­crease rates by as much as hoped. We’re also un­likely to see in­ter­est rates quickly in­crease by a large amount once they do start to move up.

Re­search from in­de­pen­dent sav­ings ad­vice web­site Sav­ings Cham­pion shows five years ago, when the base rate was 0.5%, the av­er­age easy ac­cess ac­count was pay­ing 0.74%. To­day that av­er­age rate has fallen to 0.35% and the Bank of Eng­land’s of­fi­cial rate sits at 0.25%.

MOST ECON­O­MISTS WERE NOT AN­TIC­I­PAT­ING A RATE RISE UN­TIL WELL INTO 2018

IS A RATE RISE GOOD OR BAD FOR IN­VESTORS? Many in­vestors pre­sume that ris­ing in­ter­est rates are bad news for stock mar­kets yet this is not nec­es­sar­ily the case, ac­cord­ing to data pro­vided by trad­ing com­pany Salt In­vest.

Its an­a­lysts looked at the per­for­mance of the FTSE 100 in­dex and the more do­mes­ti­cally ori­en­tated FTSE 250 in­dex dur­ing the last three pe­ri­ods of ris­ing UK base rates. The re­sults show that both the large and mid-cap indices con­tin­ued to rise in value or held firm against the back­drop of ris­ing in­ter­est rates.

‘Es­ca­lat­ing base rates may mean that in­ter­est paid on de­posit ac­counts in­creases and so the re­turns on quoted companies may be­come in­creas­ingly less at­trac­tive,’ says Salt. That lat­ter com­ment looks a bit ex­treme when you con­sider that in­ter­est rates aren’t ex­pected to jump back to the 5%+ ter­ri­tory to which many of us were ac­cus­tomed a decade ago.

The­o­ret­i­cally bet­ter rates on lower risk as­sets, such as longterm sav­ings prod­ucts, eat into the rel­a­tive at­trac­tive­ness of higher risk eq­ui­ties. How­ever, we can­not see a sce­nario in the near fu­ture where cash will pro­vide a bet­ter re­turn than the 5-6% you’ve his­tor­i­cally been able

IN THE PAST, BASE RATE RISES SEEM TO HAVE BEEN GEN­ER­ALLY POS­I­TIVE FOR THE UK MARKET

make from the stock market each year. As such, we don’t be­lieve in­vestors will rush to dump their stocks as soon as rates rise.

None­the­less, we do be­lieve that in­vestors will re­jig their port­fo­lios as there are ob­vi­ous win­ners and losers from ris­ing in­ter­est rates. We’ll dis­cuss some of the sec­tors like bank­ing and house­build­ing later in this article.

‘In the past, base rate rises seem to have been gen­er­ally pos­i­tive for the UK market,’ ad­mit an­a­lysts at Salt. ‘In­fla­tion nor­mally goes up when the de­mand for goods and ser­vices rises more rapidly than an econ­omy’s pro­duc­tive ca­pac­ity.

‘Base rates are ap­plied as a brake to al­low for mea­sured and sus­tain­able eco­nomic growth; some­thing that’s il­lus­trated by the per­for­mance of many stocks.’

A glance across the pond is worth­while. US in­ter­est rates started ris­ing in De­cem­ber 2015, the first hike in al­most 10 years.

‘De­spite a num­ber of rate rises in the US, it hasn’t stopped the Dow Jones In­dus­trial Av­er­age climb­ing 28% over the same pe­riod,’ the in­vest­ment ex­perts point out, ‘or the S&P 500 ral­ly­ing 25% to cur­rent record highs of around 2,545.’

WHAT ABOUT BONDS?

Changes in in­ter­est rates will af­fect the value of bonds in your port­fo­lio. If rates are ris­ing, newly is­sued bonds with higher

rates on the market will be more ap­peal­ing than older bonds in your port­fo­lio pay­ing less. This sit­u­a­tion can re­duce de­mand for your ex­ist­ing bonds and push down their re­sale value.

When rates are ris­ing, short du­ra­tion bonds could be more ap­peal­ing than ones with longer maturities as the lat­ter tend to suf­fer most be­cause they lock in­vestors into lower rates for ex­tended pe­ri­ods.

WHAT ABOUT YOUR OWN PER­SONAL FI­NANCES? Ris­ing re­pay­ments on your home is a big con­sid­er­a­tion if you have a tracker mort­gage. Re­pay­ing a mort­gage is the big­gest monthly out­go­ing for many peo­ple.

While the mooted move from a 0.25% base rate to 0.5% is un­likely to put a big squeeze on monthly house­hold bud­gets, a sus­tained ris­ing trend could have an im­pact.

Three or four rate rises over the next cou­ple of years – which is not out of the ques­tion – would likely mean sub­stan­tial house­hold belt-tight­en­ing.

Ac­cord­ing to the Bank of Eng­land, 43% of home­own­ers are on vari­able or tracker rates.

On the av­er­age mort­gage of £125,000, an in­crease of 0.25% would in­crease monthly pay­ments by £15 to £665. That would amount to an ex­tra £185 per year, ac­cord­ing to Na­tion­wide’s data.

But while the im­pact of the first hike may be small, some­one with a mort­gage of £150,000 could find them­selves pay­ing an ad­di­tional £161 a month if rates in­creased by 2%, ac­cord­ing to fig­ures sup­plied by the Hal­i­fax, Bri­tain’s largest lender.

Companies will also face the same test with re­gards to cor­po­rate debt re­pay­ments.

WHAT DOES THE CUR­RENT ECO­NOMIC DATA SUG­GEST?

Alan Hal­dane, the Bank of Eng­land’s chief econ­o­mist, has been at pains to high­light the pos­i­tives of a rate rise.

Such an event would be a sign of the econ­omy heal­ing, and there­fore ad­just­ing to that heal­ing process. ‘So rather than be­ing a source of fear or trep­i­da­tion, this ought to be a good news story about the econ­omy prov­ing re­silient,’ he re­cently told Sky News.

Al­though the Bank of Eng­land has high­lighted ‘pock­ets of risk’ among con­sumer debt, macro data seems sup­port­ive of rate rises, not least the in­fla­tion fig­ure which is cur­rently above the Bank of Eng­land’s 2% tar­get.

‘In­fla­tion and un­em­ploy­ment fig­ures might sug­gest a rate rise in mer­ited, but flac­cid wage growth does not,’ says Russ Mould, in­vest­ment direc­tor at in­vest­ment plat­form AJ Bell.

‘Wage in­creases con­tinue to run be­low in­fla­tion and this ap­par­ent break down in the Phillips Curve, which as­serts low un­em­ploy­ment should lead to higher wage in­creases (and vice-versa), does still seem to be a ma­jor fac­tor in Bank of Eng­land think­ing,’ he adds.

EX­PERT OPIN­IONS ARE SPLIT

Samuel Tombs at Pan­theon Macroe­co­nomics says the UK ser­vices sec­tor re­mains ‘stuck in a rut,’ cast­ing doubt over whether the Mone­tary Pol­icy Com­mit­tee will press ahead with a rate rise over the com­ing months.

‘The lat­est PMIs (pur­chas­ing

man­agers’ in­dex data) – es­pe­cially the de­cline in their for­ward-look­ing bal­ances – do not war­rant such op­ti­mism,’ he adds.

Eco­nomic ex­perts at Rus­sell In­vest­ments go fur­ther, claim­ing an in­ter­est rate rise this year against a back­drop of weak un­der­ly­ing growth would be ‘a mis­take’.

‘If the Bank of Eng­land chooses to hike rates this year, we ex­pect the un­der­ly­ing growth slow­down to take cen­tre stage again, es­pe­cially when in­fla­tion starts to roll over,’ says Rus­sell’s se­nior in­vest­ment strate­gist Wouter Sturken­boom.

A cool­ing in the hous­ing market, mixed in­dus­trial sen­ti­ment sur­veys and the de­bate over what Brexit may or may not mean for the

UK’s eco­nomic prospects are ad­di­tional com­pli­ca­tions.

STOCKS: POS­SI­BLE RATE RISE WIN­NERS

Ris­ing in­ter­est rates are con­sid­ered to be pos­i­tive for the do­mes­tic cur­rency so you could as­sume that ster­ling will strengthen near-term.

In gen­eral, the higher rates that can be earned tend to at­tract for­eign in­vest­ment, in­creas­ing de­mand for the home coun­try’s cur­rency.

Such a sit­u­a­tion im­plies a neg­a­tive out­look for the FTSE 100 which has a high pro­por­tion of over­seas earn­ers. They ben­e­fit from weak ster­ling as they get a trans­la­tional ben­e­fit when re­port­ing for­eign earn­ings in ster­ling. So a strong ster­ling has the op­po­site ef­fect and could trig­ger an­a­lysts to down­grade earn­ings fore­casts.

The big­gest ben­e­fi­cia­ries from ris­ing UK base rates are likely to be the big im­porters and the UK-dom­i­nant banks. It should be good news for re­tail­ers which source a lot of prod­ucts from over­seas, al­though they face the risk that con­sumers have less spare cash to spend in the shops if their credit card, loan and mort­gage re­pay­ments are pushed up.

Re­tail­ers which buy goods from over­seas in­clude Next

(NXT) and Pri­mark-owner

As­so­ci­ated Bri­tish Foods (ABF).

The cost of prod­ucts, in ster­ling terms, will be re­duced which should al­low for higher mar­gins and in­creased earn­ings.

We’re more cau­tious on over­spaced, struc­turally-chal­lenged shop­keep­ers. Op­er­a­tors such as Deben­hams (DEB) are best avoided from an in­vest­ment per­spec­tive, in our view, while near-term prospects sug­gest in­vestors should steer clear of

Dixons Car­phone (DC.) and DFS (DFS).

They sell higher-ticket items like mo­bile phones, lap­tops and so­fas whose pur­chase could eas­ily be de­layed by con­sumers un­der fi­nan­cial pres­sure from higher cost of ser­vic­ing debts.

WHICH BANKS LOOK GOOD?

Banks and other fi­nan­cial stocks tend to en­joy fat­ter profit mar­gins in ris­ing in­ter­est rate en­vi­ron­ments which also serve to pro­vide a lift to earn­ings and ul­ti­mately their share price.

In the­ory, that should play well for all of the ma­jor high street lenders in­clud­ing Bar­clays (BARC), HSBC (HSBA), Lloyds (LLOY), Royal Bank of Scot­land (RBS), along with smaller chal­lenger banks. These in­clude

Al­der­more (ALD), Metro Bank (MTRO), OneSav­ings Bank (OSB)

and Vir­gin Money (VM.).

Ris­ing base rates will al­low the banks to charge bor­row­ers higher rates while prob­a­bly only

pay­ing a lit­tle more to savers.

At the mo­ment we’re big fans of Vir­gin Money as an in­vest­ment as its shares trade on a low val­u­a­tion and it has con­sid­er­able growth prospects. We be­lieve it is ca­pa­ble of steal­ing a much larger market share than its cur­rent 3% or so of the UK mort­gage market.

We’re more cau­tious on Lloyds fol­low­ing the re­cent ac­qui­si­tion of credit card com­pany MBNA. In our view, this in­creases its ex­po­sure to un­se­cured lend­ing which raises the risk that the bank’s cap­i­tal buf­fers could be dam­aged if there is an eco­nomic down­turn.

STOCKS: POS­SI­BLE RATE RISE LOSERS

A ris­ing in­ter­est rate is bad for companies with high debt lev­els, par­tic­u­larly those which have to re­fi­nance their debts in the near fu­ture as they could in­cur higher re­pay­ment costs.

Con­sumer-re­lated prop­erty companies also look vul­ner­a­ble, in our view. Ris­ing mort­gage rates (off the back of ris­ing in­ter­est rates) could make it harder for some peo­ple to get on the prop­erty lad­der, thus sen­ti­ment could wane to­wards house­builders, in par­tic­u­lar.

Since the Brexit vote, shares of house­builders like Bar­ratt De­vel­op­ments (BDEV), Berke­ley Group (BKG), Bo­vis Homes (BVS), Per­sim­mon (PSON) and Taylor Wim­pey (TW.) have en­joyed a good run. Now could be a good time to re­duce ex­po­sure to the sec­tor. ‘The house­builders are sit­ting ducks, as the hous­ing market is in for a shock when rates fi­nally be­gin to rise again,’ say Salt’s market ex­perts. ‘It does look as though the cur­rent year will see earn­ings peak for the house­builders, as they get hit by the dou­ble whammy of house price in­fla­tion cool­ing off and build­ing costs ris­ing.’

At the mo­ment we like

MJ Glee­son (GLE) in the house­build­ing space as its pre­mium val­u­a­tion is jus­ti­fied by ex­po­sure to a re­silient af­ford­able hous­ing niche in the north of Eng­land. We also favour Telford

Homes (TEF:AIM) whose fo­cus on rel­a­tively af­ford­able homes in Lon­don should pro­tect its own growth prospects.

A strong run for larger house­builder Berke­ley has left it look­ing par­tic­u­larly vul­ner­a­ble to any slow­down in its high end Lon­don market. (SF)

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