The future for interest rates: will deep-seated deflationary forces defeat a US boom?
Income investors always keep a close eye on interest rates. How are we to assess the conflicting pressures at work?
WHEN are interest rates going to rise? This question is never far from the minds of income investors, such as those readers who follow this column’s recommendations. Only the return of inflation is likely to cause central banks such as the Bank of England to raise rates significantly. And the future for inflation is, in Questor’s view, to be found in a battle between strong but conflicting forces in the global economy.
On the one hand there are deepseated structural trends that could make the current climate of low inflation persist well after the last reverberations of the financial crisis have died away.
One of these trends is an excess of investment in emerging economies. This can lead to oversupply of various goods, which then have to be exported at low prices – in other words, a force for global deflation. Aiding this process are the world’s ageing populations and their need to save for their future rather than spend.
And while in readers’ minds inflation may be the norm, over longer periods it has arguably been more of an aberration.
On the other hand, some economists see signs of overheating in the American economy and predict that the US Federal Reserve could raise interest rates far more quickly than expected to prevent an inflationary boom.
It is fair to say that there are few signs of overheating in the British economy or in the eurozone, however.
There is always the possibility that a disorderly Brexit could spark inflation here if it caused sterling to fall sharply. Alternatively there is always the chance of another oil price shock. But in either case, any rise in inflation should be temporary because such one-off effects quickly fall out of the year-on-year comparisons that inflation figures are based on.
Questor’s view is that attempting to forecast the path of interest rates in light of the number of factors involved, and the way in which specific unpredictable events can change things, is a waste of time. We have all seen many predictions in the recent past proved wrong.
Instead we aim to protect investors by picking a mix of assets that should as a group produce the income we want, whether rates are high or low. Some of our holdings, such as the banks, should benefit if rates rise, while others – bonds and stocks that perform like bonds – are likely to suffer price falls, although their income should be unaffected.
Next week we will look at this point in more detail, predicting how each individual holding is likely to perform in an environment of rising interest rates.
Update: ULS Technology
ULS Technology, one Income Portfolio holding likely to benefit from rising interest rates, announced annual results on Wednesday. The Aim-listed firm acts as a link between property buyers, conveyancers, builders, lenders and estate agents, and more mortgage borrowers can be expected to switch loans when interest rates do eventually rise.
The firm’s turnover increased by 38pc to £30.7m in the year to March, and while reported profits before tax actually fell, from £3.5m the previous year to £2.7m, this was because of an increase of £1.4m in the “contingent consideration” for an acquisition. “Underlying” profits before tax were 25pc higher at £5.5m.
Net debt fell sharply from £3.5m in 2017 to £1.9m.
On the all-important questions of cash generation and dividends the company said: “The underlying position of the group is that it continues to turn a significant proportion of its profit into cash, which we expect to allow payment of a progressive dividend, while still investing in the growth of the business.”
It announced a final dividend of 1.15p, taking the total for the year to 2.3p, which represents a yield of 2.3pc at our purchase price of 99p in March last year. Numis, the firm’s broker, forecasts full-year dividends of 2.4p next year and 2.5p in 2020.
Hence the yield will remain below our 5pc target for the foreseeable future, although we bought this stock more for its growth potential. The shares have gained 28.8pc since we bought them. Hold.