Investments and higher interest rates

The US Federal Reserve’s policy committee next meets on 16 and 17 September, and a number of analysts believe that it may well announce the first interest rate increase in the country since June 2006.

Although the recent devaluing of the Yuan might push the timeline out again, it has already been a long time coming and the start of the rate-tightening cycle has been talked about for many months now. The question this raises for investors though, is what the Fed hiking rates will mean for the markets and how they should prepare for it.

“The starting point is to think about why rates go up in the first place,” says Rhynhardt Roodt, portfolio manager at Investec Asset Management. “They generally go up because times are pretty good, the economy is starting to do well and central banks start seeing some warning signs like inflation starting to pick up and the job market tightening. They want to prevent an overheating scenario and that is normally the start of the rate cycle.”

Although it is happening gradually, this is what is taking place in the US. However it is certainly not what is playing out in other parts of the world.

“The global growth backdrop is very unsynchronised at the moment,” Roodt says. “It’s very unlike the period of 2005 to 2008 going into the great financial crisis when global growth was very co-ordinated. It was predominantly led by emerging markets and China, but just about every economy in the world was expanding.”

Now, however, economies are at very different points in their respective growth cycles.

“The US is by far the leading economy in terms of where they are in the broader economic cycle,” Roodt says. “Europe is just emerging from recession, which means that things are getting less bad there, but it’s hardly robust, so they are not close to raising rates. Japan is in a similar scenario. China is on the other side of the spectrum – in a slowdown phase where growth rates are falling and they are reducing interest rates.”

This disjointed nature of the global economy makes the answer to the question of how to invest a lot more difficult and quite dependent on which markets you are looking at.

The usual response

The textbook way to manage your investments in a rising interest rate environment is to move out of defensive assets. This would ordinarily be the strategy one would pursue in the US at this point.

“You generally don’t want to own bonds when interest rates are rising,” Roodt says. “Because there is growth, you want to lean towards growth assets like equity.”

However, given the low interest rate environment we have experienced over the last five years, bonds have been unattractive for some time already. Equity markets in general are also looking fully-priced, meaning that there is less potential there than one would normally expect at this point in the cycle.

In particular, one area of the market that might usually be primed to go up at this point is currently in the doldrums.

“Within equities you would typically want to consider more later-cycle, non-defensive type shares, but again, the answer is not that simple,” Roodt says. “The companies that fit that description are typically commodities, but with China slowing I don’t think that’s the answer now.”

This is clearly an unusual environment, and one that makes stock picking and asset allocation very difficult. However, there are some standard considerations that still make sense.

“What you want to avoid are your typical bond-proxy, high-yielding, defensive sectors like utilities, healthcare and telecommunications,” says Roodt. “The hunt for yield becomes less of a theme when rates go up and those high yield sectors tend to begin to struggle. I would probably expect things like utilities and consumer staples to begin to under-perform against the broader US market should interest rates move higher.”

He suggests that more cyclical sectors like traditional IT and consumer discretionary may be the more likely winners.