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Paul Mumford: case for UK equities in face of rate rises

Paul Mumford: case for UK equities in face of rate rises

At the start of the year the Bank of England warned that interest rates will continue their ascent back to normality 'sooner and faster' than predicted.

Although expected to rise to 0.75% in May, rates remained stationary, with many now anticipating an increase later this year.

This was seemingly confirmed by Bank of England interest-rate setter Silvana Tenreyro on the 4 June, who said that although a raise was likely, the timing of one remains uncertain.

Given this uncertainty, some investors would be forgiven for getting a bit antsy about their exposure to equities.

However, it’s important to remember that these coming rate rises herald a return to reality that has been a long time - some might say too long - coming.  

But the long period of low rates we’ve experienced means that, although rises are expected, this will undoubtedly cause some pain along the way as firms adjust.

The Bank of England will need to be careful about the timing and pace so as not to squeeze the economy too much.  

Whatever happens, rate rises will inevitably hit companies with high levels of borrowing, creating a headwind where previously there was a tailwind.

Individuals with debt and mortgages will similarly feel the pain, which could adversely hit consumer confidence.

But presuming the Bank of England doesn't completely mess up the pace and timing, there will also be big positives here that investors can exploit.

It's no secret that many companies are struggling with large company pension deficits - even a small increase in rates could provide a lot of relief on this front through fund revaluation, in some cases even putting funds back in the black.

Firms in this situation - as well as cash-rich firms - could see a big net benefit from rate rises.

And of course rising rates don't just affect equities - they would have a negative impact on bond valuations, potentially putting investors off long-term securities where the yield is still low.

Given fixed income is already fairly unattractive relative to equities in the current conditions, this could exacerbate the 'nowhere else for money to go' factor, boosting equities further.

Connected with all this is the ongoing sterling saga.

Since the referendum, its fall against the dollar and euro has proved a boon to companies with overseas earnings and exporters. However, it has since picked up significantly against the dollar, and rate rises could drive it higher still.

As Britain's future relationship with Europe becomes clearer, we could well see sterling begin to regain some of its strength against the euro too.

While this would turn a tailwind into a headwind for the aforementioned companies, on the flipside it could provide a boost to domestic stocks and importers.

Retail in particular could gain a lift, with food and other perishables importers seeing the effect more immediately, followed by clothing as seasonal orders roll over.

The timing of this switch in focus will be uncertain, and could happen gradually rather than quickly - investors will need to keep a close eye on the balance and be ready to switch strategies accordingly if Sterling begins to rise.

As for the volatility witnessed earlier this year, as many have concluded, it represented more of a sharp correction (along with the typical overreaction) to certain exuberantly priced US stocks than anything else.

So we're very far from any sort of 2007 scenario. It is possible that it was a one-off, on the other hand we may well see heightened volatility for some time with a few more similar corrections along the way.

If the latter, then again this has big implications for strategy. Volatility of this sort can actually provide tremendous opportunities - it heavily favours the active manager stockpicking approach.

A nimble manager able to quickly dip 'in and out' - taking profit at the top and picking up shares on the cheap during the corrections (and with the skill to be able to time this correctly) will be able to significantly improve returns compared to a more passive fund or an active fund in a more benign, calm environment.

It also heavily favours a focus on smaller caps - both in the sense that these stocks are relatively unaffected by these sorts of swings compared to the large caps, and also in that small cap managers are inherently more nimble and able to perform the 'in and out' manoeuvre required.

It also makes diversification - important during any environment - utterly crucial. You're far more likely to get caught out by volatility with your eggs in just a few baskets.

Taking all this into account, while the remainder of 2018 could see some significant change, the case for equities is just as strong and the opportunities likely to be just as numerous; it's simply a matter of being smart about where they might move to - and how best to exploit them - in an uncertain and shifting environment.

Citywire AA-rated Paul Mumford (pictured) has returned 57.9% in the three years to the end of June versus a peer group average of 33.1%. He manages the TM Cavendish Opportunities and TM Cavendish AIM funds. 

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Paul Mumford
Paul Mumford
1/13 in Equity - UK Medium Companies (Performance over 3 years) Average Total Return: 64.60%
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