The increasing likelihood of higher interest rates in the US and UK is unlikely to cause a major headwind for equity investors, according to Hawksmoor’s Jim Wood-Smith, who says recent increases in M&A activity show corporates are in a very strong position after years of deleveraging and cost-cutting. 
The future of monetary policy both here and across the Atlantic has been the major talking point in the world of finance over recent weeks, as after six years or so years of ultra-low rates, the US Federal Reserve and the Bank of England have dropped sizeable hints that they will initiate their first hikes in close to a decade over the coming few months.
While tighter monetary policy is usually a positive signal for equity markets as it suggests the underlying economy is in good shape, many warn that higher rates could have an adverse effect on stocks this time around as investors have never had to deal with rock-bottom rates for such a long period of time.
Though fixed income is the most vulnerable asset class to a hike, bears warn equities will undoubtedly be caught out as well given that very loose monetary conditions have been one of the major drivers of the rally since the global financial crisis after investors were forced to take ever increasing amounts of risk to find an acceptable rate of return.
Performance of indices since global financial crisis
Source: FE Analytics
Wood-Smith, head of research at the group, says that these concerns about financial distortions have been overblown, however.
He points out that this increasing negative sentiment is characteristic of the summer months, as falling trading volumes and slow news flow cause investors to wait with bated breath for action to resume.
Nevertheless, he says there have been a number of positive developments over recent weeks which suggest investors can afford to be more bullish than many headlines suggest.
“Markets have stumbled into August on autopilot,” Wood-Smith (pictured) said. “Europe is on holiday for a month and most of the UK has moved to Cornwall after giving up trying to get to France. Like Operation Stack, this is a waiting game.”
“Waiting to see when the Chinese government is going to react to the sharp weakening in the manufacturing sector. Waiting for the Fed and the Bank of England to raise interest rates. Waiting for Greece. Waiting for Godot.”
He added: “But if markets think there is nothing to be done, others are acting differently.”
Wood-Smith points out that Zurich Insurance has dropped big hints about its plan to buy Royal Sun Alliance while SJP has agreed a takeover of Rowan Dartington. Elsewhere, Delphi has bought HellermenTyton, Melrose Industries is in the process of selling part of its business to Honeywell while GKN has acquired its Dutch competitor Fokker.
“It may have been an unusually active week, but this is all hugely encouraging stuff for investors,” Wood-Smith continued.
“As a generalisation, companies have been terrified to do anything with their cash since the Great Financial Crisis. Plan ‘A’ has been to pay it back as dividends to equally terrified shareholders, who then wondered why companies weren’t growing.”
“This has the strong whiff of an increase in corporate investment spending.”
Nevertheless, many fear the prospect of higher interest rates will cause volatility in both bond and equity markets akin to the 1994 sell-off, when an unexpected US Fed hike caused prices of drop across the board.
Performance of indices in 1994
Source: FE Analytics
These include the likes of Old Mutual Global Investors’ John Ventre who recently told FE Trustnet that he had moved into “full risk management mode” across his fund of funds ranges in preparation of higher interest rates.
“I think the potential for a US rate rise is the main risk to markets, as you have to think that the Greece and China-induced volatility as acted as a mirage,” Ventre said.
“The reason I am nervous, which is quite rational, is that we have never seen anything like this before. We have never seen rates rise this late in the economic or market cycle. Normally, a rate rise is confirmation to equity markets that the economy is in solid shape.”
“Of course, you could interpret it like that this time, but I feel the cat is somewhat out of the bag as when you look at the multiples in the US, it doesn’t look like a market which is struggling for good news.”
According to FE Analytics, the S&P 500 has been the only major developed market index to deliver positive gains in each of the last six calendar years and is currently trading on a P/E ratio of more than 20 times.
It is also outperforming the MSCI AC World ex USA index so far in 2015 with gains of 3.11 per cent.
Source: FE Analytics
Ventre added: “For the time being, I think the circumstances warrant caution because after years of extremely loose monetary policy, the punch bowl is being taken away.”
Others are even more bearish, such as Peter Spiller at Capital Gearing. He warns that policies such as ultra-low rates and quantitative easing have done nothing but distort valuations and add more debt to the system since the crisis, leaving risk assets very vulnerable. 
“Markets are enormously distorted. In our view, there is no asset class out there that will make a positive real return over the next 10 years. We can make that statement with certainty for bonds, but we believe it is generally true across all other asset classes,” Spiller (pictured) said.
“It is very different from the equity market peak in 2000 because then some parts were driven to absurd levels while others were really cheap. Now, there is nothing [that is cheap] on our valuation basis.”
Wood-Smith disagrees, however. He says equity investors can afford to keep their long-term horizons and that if there are to be any rate-induced sell-offs, they should be viewed as buying opportunities.
He points to the fact that markets in the US have continued to perform well since the Fed ended quantitative easing last year and says there is no reason why higher interest rates will cause a severe downturn.
“Remember how no-one is querying how the US economy will fare when it is taken off life support? The plug was pulled out of the iron lung last October without any apparent ill effects. Instead the chatter now is how the economy will stand up to ‘lift-off’, the first rise in rates since June 2006,” he said.
He added: “In all probability, the answer will be the same. The economy will keep going very nicely thank you.”
