Although it is most unlikely to occur in the short term, there are reasons why an increase in interest rates, in the UK and elsewhere, would be most welcome. While savers would be incidental beneficiaries, the key point is that modest increases in interest rates would provide a signal that central bankers were beginning to feel that recovery is becoming more entrenched so that less intervention is therefore necessary, or appropriate. We are of course some way from this in many parts of the world but there are signs that, in the USA in particular, recovery is becoming established and the Federal Reserve’s Quantitative Easing (QE) programme could start to be scaled back as the year progresses.
Market movements towards the end of May indicated how sensitive both fixed interest and equity prices might be to this development. In the case of the former, where central bank purchases of Government bonds and other fixed interest instruments have pushed prices materially higher, a running down of this support could have a considerable adverse impact on fixed interest values which might commence before any actual interest rate increases take place. Therefore, a run-down of QE, leading potentially to its cessation (as may already happened in the UK,) carries fixed interest risk in particular and will need most careful management as and when prospects for stability and growth re-emerge more widely.
In Japan there is a very different picture in that large scale QE looks set to be underway for some time as the new Government is determined to reverse the damagingly deflationary spiral that has been entrenched there for many years.
All of this leads me to conclude that we are right to continue to underweight fixed interest exposure within client’s portfolios as the long bull market in this asset class looks to be heading towards a gradual conclusion over the next two or three years.
Equities, on the other hand, are in a very different situation, being generally much less exposed to interest rate movements than they were say five years ago as a consequence of action taken to build profits, restore balance sheet strength, and reduce costs by, among other things, paying down old high interest rate debt and where necessary replacing it with new lower cost facilities which will stand them in good stead for years to come. I consider it highly unlikely that central banks will either back pedal on QE or push interest rates higher without most careful consideration of the result of their actions on the corporate sector, so that in my view May’s equity market correction has been overdone in much the same way as one can argue that markets rose rather too quickly in the earlier months of the year.
In summary, equities continue to offer sound medium term value and where it is appropriate from a risk perspective, we continue to be overweight in the sector. Fixed interest investments are fully valued, but of course remain appropriate for many, particularly in the context of tax advantaged accounts, including ISAs and pensions.