Written by Justin Onuekwusi, Chief Investment Officer at St. James’s Place
Since my last quarterly update, summer has arrived, bringing not only warmer weather but also the drama of Euro 2024. The season has also been marked by political theatre, with unexpected snap elections in both the UK and France – events that few could have predicted just two months ago.
Despite the election outcome offering more clarity on the UK’s political direction, economic challenges remain. Interest rates are going to stay in the spotlight, and that will impact on how we all plan our investments moving forward.
Current expectations suggest a fall in interest rates towards the end of the year. But even if rates come down, they are unlikely to return to prepandemic levels.
As we chart a course through this ‘higher-for-longer’ era, our priority remains clear: to manage the impacts thoughtfully and strategically, ensuring that clients’ investments are well-positioned for both the challenges and opportunities that lie ahead.
Our three messages for this quarter are:
- Persistent inflation pressures will mean a more cautious approach to rate cuts by central banks.
- Ultra-low interest rates seen before the pandemic are unlikely to return.
- Investment success is best achieved by focusing on long term goals and not speculating on market reactions to interest rate changes.
Understanding the transition from low to high interest rates.
Five years ago, it was easy to assume rock-bottom interest rates would stick around forever. Low mortgage payments were almost taken for granted.
That all changed in 2021. Supply shortages due to the Covid-19 pandemic combined with Russia’s invasion of Ukraine triggered inflationary pressures that had been dormant for years.
Central banks, including the Bank of England, responded by raising interest rates. The goal was to cool the economy by making borrowing more expensive, reducing consumer and business spending to help rein in inflation.
Between 2021 and 2023, the Bank of England increased interest rates 14 times, eventually holding them at 5.25%.
The squeeze on households
For most of us, mortgages or rent take the biggest bite out of our budgets – and we’ve definitely felt the pinch as higher interest rates press down on both, cooling house prices and curbing the demand for residential properties.
Central banks face high-stakes decisions
Now, after years of hiking interest rates, attention is turning to how quickly and easily central banks can reverse course.
In June, Canada became the first country in the G7 to cut rates, suggesting it believes inflationary pressures are subsiding. The European Central Bank opted to lower rates soon after, indicating a similar sentiment.
In the UK, consumer price inflation has fallen back to the Bank of England’s 2% target, but service sector inflation remains over 5%. Before the Bank decides to relax its monetary policy, it will want to ensure inflation is fully under control, so the first cut could be delayed until the Autumn.
Inflation has proved even stickier in the US, hovering around 3% compared with the Federal Reserve’s 2% target. This could mean we see an even more cautious approach to cuts from the Fed.
Central banks globally are navigating a precarious balancing act: promote economic growth by cutting the cost of borrowing, but risk igniting further inflation.
A dip, but no deep dive
The most widely held view is that interest rates, both in the UK and elsewhere, will decline from their current levels, but settle at a level higher than before the pandemic. In other words, a return to near-zero interest rates is extremely unlikely.
Adapting to this ‘new normal’ of higher rates will present challenges and opportunities.
The new normal?
UK interest rates around 5% may feel unusually high after years below 1%, but this reflects a move back to more typical rates.
Equities
Historically, elevated rates have been associated with higher, not lower equity prices. This is because higher rates often come at a time of higher levels of economic growth, which can be beneficial for company profits.
However, businesses that are heavily indebted are likely to face increased financial pressure under these conditions. Focusing on companies that are less sensitive to higher interest rates, especially those with strong balance sheets, low debt levels, and solid cash flows, can be prudent.
Nevertheless, diversification across various sectors and regions remains our key focus. Leveraging the expertise of our externally appointed equity managers along with in-house specialists helps us to identify a wide range of potential investment opportunities.
Bonds
Interest rates have a big impact on bond yields. When interest rates are high, bonds come with higher yields because they need to be attractive enough for investors to buy them. If interest rates are expected to stay higher for longer, then the yields on existing bonds are likely to remain relatively attractive for a while. This marks a departure from recent years when low interest rates made bonds less appealing.
We believe that bonds can once again provide effective diversification, offering predictable returns and less volatility compared to other investment types. This improved outlook for bonds is reflected in our latest portfolio allocations.
Alternatives
Alternative investments, which can include assets such as commodities, private equity, and hedge funds, offer several key advantages. Some have a lower correlation with standard asset classes, while certain types, particularly commodities, can be effective hedges against inflation.
However, with bond yields becoming more attractive, the bar for incorporating alternatives into our portfolios has been raised. This is because the risk versus return on alternatives is not as favourable as what bonds are now offering.
Real vs nominal interest rates
Understanding the ‘real’ interest rate is key since it reflects the actual earnings on cash savings after inflation. For example, with nominal rates at 4% and inflation at 5%, the real interest rate would be -1%.
Summary
Given the possibility of one or two rate cuts this year, amidst a broader higher-for-longer outlook, sticking to our core investment principles remains crucial. Trying to guess short-term market moves or reacting to the latest news could prove costly.
Ensuring we keep our investment portfolios diversified across different assets, sectors, and geographical locations will help to manage risk. This becomes especially relevant when there’s uncertainty around interest rate movements, as not all investments will react the same way to changes.
