Speculation over the timing and severity of a hike in the base rate by the Bank of England from five years of historical lows has intensified recently, with many experts citing it as a potential headwind for equity investors.Martin (pictured), who heads up the five crown-rated Neptune UK Mid Cap fund, says that provided the Bank is able to keep to "baby steps", the raising of interest rates will be bullish for the equity market generally.
“Although it is not our base case at Neptune, we are watching out for any developments – especially supply-related – that might force the Bank to raise interest rates sharply,” he said.
“At an asset class level, bonds would underperform in the event of a sustained rising interest rate cycle. We would expect equities generally to perform well, although sectors that behave similarly to bonds – typically real estate and utilities – are likely to underperform in relative terms.”
Over the past five years, bonds have been in a strongly rising bull market while the average fund in the IMA Property sector has made almost 50 per cent.
Utilities have also seen rapid gains, with the FTSE All Share Utilities index rising 111.09 per cent over the same period.
Performance of indices and sector over 5yrs
Source: FE Analytics
Meanwhile, housebuilders have been among the biggest winners in the FTSE All Share since markets began to recover in the aftermath of the financial crisis.
Taylor Wimpey and Barratt Developments were some of the worst hit in the crisis, losing up to 96 per cent of their value before bottoming out.
They have made 255.7 and 362.59 per cent respectively over the past three years as positive sentiment has returned to both the housing market and the broader UK economy. Government schemes such as Help to Buy also buoyed the market.
Persimmon and Berkeley Homes have also made huge gains, rising 196.32 and 104.51 per cent over the same period. By comparison, the FTSE All Share gained 46.16 per cent.
Performance of stocks and index over 3yrs
Source: FE Analytics
However, Martin says the stocks will fare significantly worse as rates begin to rise.
“Housebuilders such as Taylor Wimpey have been big beneficiaries of ultra-low interest rates and, at least in the short-term, we would expect relative weakness in housebuilders as housebuyers potentially become more reticent about taking on large mortgages in a rising interest rate environment,” Martin said.
The stocks are popular holdings and feature in the top-10 of a number of funds.
Eleven funds hold Taylor Wimpey in their top-10, including Richard Buxton’s Old Mutual UK Alpha fund, the CF Odey Portfolio, GLG UK Income, Royal London UK Mid-Cap Growth and Henderson UK Smaller Companies.
Barratt Developments is held by the Old Mutual UK Equity and Old Mutual UK Mid Cap funds in their top-10.
Twelve funds hold Berkeley in their top-10 including Dimensional UK Smaller Companies, City Financial UK Opportunities and Franklin European Growth. No funds hold Persimmon in their top-10.
Martin also believes that when interest rates rise, mid and small caps should outperform large caps again.
Performance of indices in 2014
Source: FE Analytics
“The FTSE 250 Mid Cap index, which historically has fallen more than the FTSE 100 in bear markets but risen more in bull markets, should again perform well in a rising equity environment.”
Martin says wealth managers such as Rathbones and insurance brokers such as Jardine Lloyd Thompson will be likely beneficiaries of increased returns on cash holdings, and should therefore see an appreciation in their share price.
Ten funds hold Rathbones in their top-10, including BlackRock UK Smaller Companies, BlackRock UK Special Situations, F&C UK Smaller Companies and SWIP UK Smaller Companies.
However, Martin warns a crucial marker of the success of the normalisation of interest rates will be the speed at which they rise.
He says this is likely to be slow due to the clear concern that a rapid rise is likely to knock back both the housing and consumer market.
“Baby steps’ has been the expression used by Mark Carney for the speed of interest rate rises. This is largely due to the high levels of household debt in the UK and the nature of those debts. The average household in the UK has liabilities significantly greater than the US, for example, as a percentage of disposable income,” he said.
“In addition, the UK has a much greater proportion of variable rate mortgages than the US: roughly 14 per cent of mortgages in the US are variable compared with roughly 67 per cent in the UK. Even where UK households do have fixed rate mortgages, they are typically five-year fixes compared with 30-year fixes in the US.”
“All of this means that the Bank of England will be keen to raise interest rates very slowly.”
However, while certain experts have warned that rising interest rates could create volatility in the equity market, Martin says the fact that the Bank of England is moving earlier to combat higher inflation is a good sign.
FE Alpha Manager Martin has run the £263m Neptune UK Mid Cap fund since its launch in December 2008.
According to FE Analytics, it has been the sixth best performing portfolio in the highly competitive IMA UK All Companies sector over this time with returns of 260.04 per cent and has beaten its FTSE 250 ex IT benchmark by close to 45 percentage points.
The fund has an ongoing charges figure (OCF) of 0.81 per cent.
