The only way is up
Brian O’Reilly reviews the investment implications for charities where inflation pressures are building and interest rates can only rise
KEY POINTS
- Government austerity measures a drag on growth
- Inflation remains a concern
- Fixed assets have performed well in tightening economic cycles
- Any interest rate hikes must remain gradual
The global economic crisis has split the investment community between two camps. One side expects deflation, while the other is worried about inflation. As many will remember inflation was a real bête noire in the 1970s, but has played an extremely minor role in industrialised countries over the last 25 years. But is this about to change?
In the aftermath of the financial crisis once again inflation pressures are building, nowhere more so than on our small island. The latest official figures indicate that headline CPI looks set to breach 5 per cent in the coming months. True, some of this increase is due to temporary factors such as higher VAT and rising commodity prices, but they don’t explain all the increase. More worryingly households are responding to higher prices, and perceptions of future inflation are rising rapidly.
Inflation is at risk of becoming a persistent problem
There are a number of reasons to believe that inflation pressure will persist beyond the current tax and commodity increases.
For one, since the crisis began, monetary expansion has been on a scale not seen before. Let's not forget that interest rates remain at their lowest level since 1692, and £200bn of QE has already been pumped into the economy.
There is a risk that in time, this stimulus will find its way out into the broader economy once the transmission mechanisms such as banking credit lines are repaired.
Secondly, the last 20 years were marked by a low and stable inflation environment. Emerging economies, particularly China, exported deflation providing cheaper and cheaper goods to consumers in the West.
Now with an increasing focus on driving domestic demand within these developing nations, wages are rising apace, as are their currencies. The combination of which will probably mean that they will begin toexport inflation in the future.
BoE will have to normalise rates at some stage
In this environment it is my view that it will be increasingly difficult for the BoE to meet their 2 per cent target going forward. Currently the nine members of the MPC are split on the appropriate response, but some central banks including the ECB, have already moved to raise interest rates despite the problems on the continent’s periphery. While the timing of the first rate hike is difficult to predict, it seems clear that at some stage the MPC will also have to begin the process of interest rate normalisation, to counteract building inflation pressures.
In response, charities should begin to plan ahead and factor in the possibility that a rate tightening cycle could impact on their investment portfolios. Portfolios that consist largely of nominal assets will be exposed to a greater loss of purchasing power in a higher inflationary scenario. Since the cost of living would rise and at least nominally fixed income would decline in value, this development could pose the risk that long-term investment objectives will not be met.
To ascertain how different assets typically behave in such an environment, below we examine the historical performance of bonds, equities and real estate during previous rate tightening cycles to try to understand some of the dynamics driving investment performance.
Lessons of history
Gilts lag
Figure 1 shows the total return performance of UK equities, gilts and commercial real estate in the periods following previous rate hikes back to the 1977 (data available from 1994 for real estate). Historically, equities and real estate have returned on average 30 per cent and 27 per cent respectively in the two year period following the first hike. As one would expect, the outlook for gilts becomes more challenging in an environment of rising interest rates, but despite several periods of weak returns, on average gilts still managed to return 15 per cent in the two years after the first rate hike. This suggests that the market had already priced in the prospect for higher rates prior to the BoE decisions. So far so good.
Managing inflation expectations is crucial
However, as always we need to be careful in extrapolating too much from historical data. 1994 appears to have been a good year for bond investors, but in fact it was one of the worst annual years on record as the market had sold off heavily prior to the first rate hike, with bond yields at one stage down by ten per cent on the year. Not what one would expect from a ‘risk free’ asset.
We find however there are some dynamics worth exploring further from the historical analysis, particularly in the 1970s and late 1980s, where the transition to higher rates didn't go as smoothly. We believe these two periods underline the importance of the BoE restoring its inflation fighting credibility, as large bond declines during this period were typically due to an unanticipated spike in inflation. We hope the BoE don't make a similar mistake this time, but the longer they let inflation run higher the greater the likely-hood of such a scenario unfolding.
Equities and real estate outperform
The case for real assets is more encouraging. Despite the risk of policy errors around the onset of a tightening cycle, equities and real estate tend to be the best performing asset classes. Real estate performed well in the last five tightening cycles, and in some cases delivered gains in excess of 30 per cent. Typically, however, rate hikes have occurred in the middle of real estate cycles and, as such, played little part in the long-term return prospect for property. The episode worth taking note of however is following the last property collapse in the early 1990s. Gains were more muted post 1994, and we believe we may be in for a similar period this time, as we explain later.
A closer look at equities
In the case of equities, the data shows that investors tend to get nervous around the beginning of a rate hike, and returns are muted at best in the subsequent three to six-month period.
However, as the market assesses that central banks are not choking off the recovery, growth stabilises and the market moves to a new stage of the cycle in which higher economic growth follows through to earnings, which ultimately drive markets higher. We believe there is enough global economic momentum for profits to remain strong for now and this should drive equities higher.
Equities: rational exuberance
Equity markets have managed to absorb a series of shocks in the last few months, including continued unrest in the Middle East, rising oil prices, the tragedy in Japan and, of course, the Greek debt crisis. Given this uncertainty we recognise that equities could be range bound in the near term, but longer term we believe investors should be increasing their equity holdings on any pullbacks. Global growth supports earningsWhy? We already believe equity valuations are discounting a lot of uncertainty. Opportunistic investors may use any weakness around the onset of rate hikes to increase their equity holdings. With 70 per cent of FTSE 100 sales derived outside of the UK, even in the worse case scenario, the largest investable companies should be relatively well sheltered from a fragile domestic situation.
Valuations are not demanding
What really reassures us about equities is their valuations. Despite the fact that the FTSE 100 is up 65 per cent since the lows in 2009, the UK is also the cheapest developed market globally. The MSCI UK index is trading at just over 10 times forward earnings. In addition, analysts forecast earnings to grow 17 per cent in the next twelve months. Dividends are recovering strongly, and this year alone we expect up to £53bn to be distributed to shareholders, another dynamic we particularly like in a period of higher inflation. Underpinned by attractive valuations and solid earnings, we believe investors should increase their equity holdings.
Gilts: they think it's all over...
In the past 20 years bond investors have become accustomed to an environment of low and stable inflation supported by accommodative monetary policy. But now, some are calling for the bursting of the bond bubble. Our assessment of the outlook for the bond market is weak at best, but we don’t subscribe to some of the more extreme views, as we believe the BoE can engineer a less volatile transition to a more normal rate environment. See Figure 3.
Rate increases should be gradual
The timing and scale of monetary tightening will play a crucial role. Gilt yields have been kept artificially low by unprecedented central support since the onset of the financial crisis, but now attention has begun to focus on the investment implications of higher interest rates in the year ahead. The BoE will have to be careful to communicate that any future rate hikes will only be gradual. We expect a slow transition to higher rates, and in terms of a rate tightening cycle, it is more a normalisation of monetary policy rather than anything more draconian.
Gilts do not compensate for inflation
With inflation running above four per cent, current ten-year gilt yields do not provide sufficient compensation and we expect inflation expectations to move higher. Our twelve-month forecast for ten-year government bonds is 4.5 per cent.
Author: Brian O'Reilly
Brian O'Reilly is the chief investment strategist and head of research at UBS Wealth Management where he manages a team of analysts, economists and strategists.
He joined UBS Warburg ten years ago from Goldman Sachs and has held various positions as an economist and investment strategist working in both New York and London.
There are no comments on this article. Be the first to comment.