Investors should consider a wholesale overhaul of their investment portfolios in light of the strongest suggestion yet that UK interest rates will rise sooner than they expect, according to Chris Williams, chief executive of financial advisors Wealth Horizon.
While all nine members of the Monetary Policy Committee – the Bank’s interest rate setting body – voted unanimously to hold rates at their historic low of 0.5 per cent last month, reading between the lines of their discussion suggests several members are becoming increasingly concerned that inflation poses a looming threat.
This builds on hints made last week by governor Mark Carney that he may raise rates sooner than many have been expecting.
Williams said: “Carney has for a long time outlined plans to keep rates low for a sustained period, but his announcement last week shocked markets when he revealed that interest rates might be hiked this year.”
“For investors, now is the time to prepare for a changing landscape in which many of the strategies that have been adopted in the low interest rate environment need to be reviewed and reconsidered.”
Williams says the primary portfolio concerns should be around exposure to fixed income funds and markets, as well how large currency movements may shift the value of the different underlying holdings.
“When interest rates rise, it is typically a signal of an improving economy, but many asset classes actually struggle in this environment. For example, fixed interest investments tend to struggle as cash starts to pay more interest. Now could be a good time to reassess your investment strategy and asset allocation to ensure your portfolio is well diversified.”
According to FE Analytics, the iBoxx Sterling Gilts and Corporate bond indices have rallied almost without any hiccup as far as our data goes back, to 1998. However since the start of 2015, there has been some downwards movement in both indices of about 5 per cent.
Performance of indices since 1998
Source: FE Analytics
However, the last time interest rates rose – back in April 2003 – most UK bonds as well as the broader market Investment Association fund only suffered a minor blip before bouncing back later in the year.
Performance of sectors and index in 2003
Source: FE Analytics
Many experts have told FE Trustnet that they are worried too many investors could head for the door at the same time and cause a material sell-off when rates rise. In the case of the largest bond funds, this could cause significant problems through issues such as a lack of underlying liquidity.
Williams adds that other holdings such as equities, both those listed in the UK and abroad, could be negatively affected because of changes in the relative value of these shares, as well as the impact on their earnings – as many firms in the FTSE 100 see these originate from abroad.
“Fluctuations in currency prices are closely linked to interest rate rises. This could be good news for sterling, which may gain momentum against other currencies because higher rates attract foreign investment,” he said.
“Whilst this can be good for some investments, a soaring pound will impact earnings of equities and other investments so be mindful of the potential impact on your portfolio.”
Simon Smith, chief economist at currency dealer FxPro, says the recent soaring pound since Carney’s comments could experience further traction.
“Naturally, his is only one view of nine on the committee, but if there is a sense that things are shifting towards his way of thinking, then sterling may seek to regain some of the recent gains against the dollar.”
Performance of dollar versus pound over 1 week
Source: FE Analytics
Williams also advises investors to stay out of cash and remain invested as while interest rates on deposits often rise when the benchmark rate rises, they may not offer the same returns and therefore not protect against a ramp up inflation.
“For savers who remember the heady days of bank accounts paying 5 per cent interest, the prospect of a rate increase will come as a blessing,” he said.
“Yet, if you are looking to gain an income from your cash, it is important to remember that any interest rate rise will be marginal and remains dependent on banks actually passing it on to savers. Therefore, you should consider investing your money rather than leaving it in cash.
When it comes to timing of the Bank’s first rate hike, AXA Investment Managers senior economist David Page says faster than expected growth in UK private sector wages puts the spectre of a ramp-up in inflation in sight and that only international concerns, primarily Greece, put the committee’s members off voting for a hike this month.
“The decision between holding the bank rate at its current level versus a small increase was becoming more ‘finely balanced’ with the risks to medium-term inflation outlook ‘becoming more skewed to the upside’. ‘Most members’ continued to see inflation risks balanced, suggesting that ‘a number of members’ was, at most, four,” he said.
“Our own view remains that a February hike looks most likely, expecting further sterling appreciation and downside risks to oil prices as exacerbating extremely low headline inflation in November. Financial conditions look set to tighten in Q4. However, we acknowledge that surprisingly firm wage growth could convince members of a need for a hike this year.”