Active investment commentary & analysis

Think carefully before reacting to rising interest rates

Should stockmarket investors be worried about rising interest rates? What is welcome news for savers with cash in the bank, can be a warning of challenges ahead for shares and bonds. But, while it is a time to be more aware of the risks in shares, it may not yet signal the end of the economic cycle. Global growth remains robust, and there is little sign that inflation is out of control. Rather than running for the exit, investors need to think carefully about the focus of their portfolios.

Sharp market falls - even ones of 10 to 15% - are painful, but also create opportunity. There are winning and losing businesses at all stages of the economic cycle. Stockmarket progress often follows a shaking-out of more nervous and indiscriminate investors.

However, the shift in inflation expectations should concern investors in bonds and gilts. The last 10 years has been an extraordinary one for monetary policy, and central banks are moving back towards more normal behaviour. Bond investors may have been lulled into a false sense of security. Some governments and companies have been able to borrow on unrealistic terms that do not seem to recognise their credit history. The role of bonds in a portfolio is to provide resilience, but in the financial crisis many bonds behaved much like equities. The search for yield in recent years has driven many investors into riskier or less liquid assets.

Bursting bubbles in bitcoin and other crypto-currencies should prove healthy for stockmarkets. Speculators had also been drawn to some esoteric investment products, betting on investor complacency and low stockmarket volatility. Fortunately that speculation has now ended before it became too widespread. These shocks are a reminder that there are dangers in many complex financial instruments and company profits and dividends matter. For companies that have yet to move into profitability, it is important that business targets continue to be met. Higher interest rates create a headwind for attracting further finance.

It is likely that some businesses dependent on UK consumer confidence will disappoint this year. Consumer credit is stretched, with little room to borrow more. There may be risks in consumer-oriented, cyclical and low-margin businesses. The relentless rise in internet shopping means that many high street retailers are struggling. Indeed, a range of sectors - from retailers, to banks and cars – are being disrupted by new entrants. This is not just driven by new technology, but a change in tastes that favours experiences over things. Millennials have little respect for longstanding brands.

Investor nervousness means that any companies that disappoint are now being punished severely. Sharp share price falls are a likely reaction to any disappointment in earnings, as investors radically revise expectations. Higher interest rates may also be more of a challenge for shares that are propped-up solely by dividend yield, with little real growth. And investors need also to factor-in politics. Already, this has hit utilities and transport businesses.

The bonus for private investors this year is that the new MiFID regulations on investment research have brought more interest to medium-sized companies. Major investing institutions find it harder to build-up meaningful portfolio investments in these companies. Some of these are to be found on the riskier Alternative Investment Market, favoured by private investors. And many smaller companies have realised that they must pay for research themselves, and encourage free distribution of information to shareholders and potential investors. This will help to level the playing field for individuals buying shares versus the big funds. For diligent private investors, more information may be available, with the caveat that it may be less independent and critical. Sifting through smaller companies for the gems should become easier. Stockmarkets may be more volatile this year, but longer term investors should view this as opportunity.

A version of this article was published in the Herald on 24th February 2018.