The decision by the Bank of England (BoE) to raise interest rates by 0.25% to 0.5% on 2 November marks a turning point for UK monetary policy. It is the first interest rate hike in a decade.
BoE governor Mark Carney said another two rate rises may be needed in the next three years to control inflation. In theory, this places the UK on a gradual path towards ‘rate normalisation’, following in the footsteps of the US Federal Reserve, which has raised rates four times since the financial crisis.
How will multi-asset portfolios be affected by the rate hike? Ian Rees, Premier’s Citywire + rated head of multi-asset research, says it is important to think about why interest rates are moving up.
‘If it’s a result of strong economic data, then this would be a good backdrop for equities to maintain their upward trajectory,’ said Rees. ‘We also envisage anything floating rate will benefit on the back of rising rates. Even absolute return funds will find generating returns a little easier as cash rates improve.’
High rates, low returns
On the other hand, higher rates could result in a prolonged period of disappointing returns from bonds. Low interest rates and central bank bond-buying activity have caused government bond prices to rise and yields to fall.
In contrast, rising interest rates typically cause yields to increase and the price of bonds to fall, resulting in capital losses. Rees does not expect a bursting of the ‘bond bubble’, but forecasts lower returns and greater levels of volatility in the asset class.
To counter this risk, some multi-asset managers have lowered interest rate risk, known as duration, across bond allocations. This has been the case for the Premier Multi-Asset Distribution fund, which currently has a duration of around three years.
The FTSE Actuaries UK Conventional Gilts All Stocks Index, by comparison, has a duration of nearly nine years. ‘We used a mix of shorter duration credits and floating rate debt to achieve this,’ Rees said.
Anthony Rayner, manager of the CF Miton Cautious Multi Asset fund, has also lowered interest rate risk. As a large portion of the UK stock market derives earnings from overseas, Rayner suggests the interest rate rise is ‘largely irrelevant’ for these stocks. It will only have a bearing if it causes a significant move in sterling. In any case, the fund has a low allocation of only 6% in UK equities.
‘Typically, the domestic bond proxies might be expected to do less well: for example utilities, but also certain parts of the bond market,’ Rayner added.
Planning and preparation
In contrast, some companies with greater economic sensitivity could benefit. For example, some commentators expect the rate rise will help banks increase net interest margins.
Nathan Sweeney, senior investment manager at Architas, agrees more defensive stocks, or bond proxies, will be adversely affected by the rate rise. This is because the stable income streams they offer appear less attractive when bond yields rise.
Ahead of the UK interest rate rise, Sweeney’s team reduced exposure to funds with a quality or high dividend focus, in favour of those with a value tilt.
‘For example, funds with higher weightings to commodities and financials, such as Majedie UK Equity,’ he pointed out.
Architas has exposure to less mainstream parts of the UK fixed income market via the Insight Libor Plus fund.
‘It has exposure to asset-backed securities,’ said Sweeney. ‘The interest payments from those leased assets have inflation protection and the duration on the assets is very short,’ Sweeney explained.
‘We see this as a proxy for corporate bonds. We’ve added that to our portfolios as an exposure to reduce risk and duration,’ he said.