Interest rates could rise, despite inflation dip

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For adviser use only

 

Inflation figures for June revealed an unexpected fall in the CPI rate to 2.6% after seven months of rising rates and May’s high of 2.9%. The announcement led to speculation that inflation is now at – or is close to – its post-Brexit-vote peak, and that an interest rate rise could, therefore, be kicked into the long grass.

The recent inflation dip was largely the result of falling oil prices, which offset rising food and import costs. However, inflation remains above its 2% target and only time will tell whether this result will be sustained or a blip in an otherwise upwards trend. Amid the media speculation, we believe advisers should be careful not to overstate the importance of one figure and must remain cognisant of the broader market environment. Continued high inflation; increases to the Fed’s central rate; and the prospect of a ‘softer’ Brexit following the recent general election result, are all sound reasons why rates rise could still occur later this year.

So while this relaxation of inflationary pressure certainly makes an interest rate rise at the next Monetary Policy Committee meeting unlikely, my view is that advisers should continue to prepare their clients’ investment portfolios for a rates rise in the not-too-distant future. While a rate rise would no doubt be heralded as a positive sign of economic health, it presents new challenges, and new opportunities, for those owning investments whose valuations are linked with interest rates.  

Will continued high inflation trigger rates increases?

Since the credit crunch of 2008 and 2009, UK base rates have been at historic lows.  Indeed interest rates have been low for such a prolonged period that the economy has become increasingly reliant on cheap money and quantitative easing has proven difficult to unwind.

Interest rates are the main lever for keeping inflation near the Bank of England’s 2% target.  However, a number of factors are making it difficult for the Monetary Policy Committee to sustain a ‘wait and see’ approach.

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With the exception of June’s result, there has been an upward trend in inflation since 2015, which accelerated after the Brexit vote, taking us to the highest rate for over five years in May. The Bank’s sample of external forecasters averages an inflation assumption of 2.8% for 2018. The risk is that if inflation becomes embedded above the 2% target, it will trigger further ‘cost push’ pressures and wage increases. Such a scenario would lead to interest rates materially higher than the current yield curve implies over 2017 to 2020.

The impact of US rate rises and global growth

With the US Federal Reserve (Fed) raising its central interest rate several times in recent months, further rises anticipated over 2017 and 2018, and accelerating global growth – there will also be broader macro pressure on UK rates.

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UK interest rates broadly mirror those of the US over time. While there can be periods of low correlation – such as 2001-2007 – the UK tends to follow a similar pattern to the United States and further US rate increases could be reflected in the UK over 2017-2018.

What about Sterling?

We expect the drop in Sterling that followed the announcement of June’s inflation figures to be short-lived, and Sterling may ultimately prove to be stronger and more stable than Theresa May’s government.  

First, with the government’s slim parliamentary majority, it will be politically difficult to control demands for higher public spending or impose higher taxes. Therefore, the annual deficit and government borrowing will be higher for longer. This will transfer the pressure to control spending on to the monetary policy makers, driving interest rates even further above the current yield curve over time.

Secondly, the new parliamentary arithmetic raises the probability of a ‘soft Brexit’ in which the UK manages to sustain favourable terms of trade with the EU in exchange for trade offs around three other Brexit factors:  annual payments, immigration, and sovereignty. The UK’s future trading relationship with the EU could be better than current market consensus, providing a catalyst during 2018 and 2019 for sterling to rise back towards its pre-referendum levels.

How will an interest rate rise impact asset classes?

In summary, all asset classes feel richly valued and Aegon takes a cautious view in aggregate.  We should be especially cautious in four areas: fixed interest, real estate, non-sterling assets and US equities.

Aegon’s asset class conviction list

Asset ClassOverall conviction
Equities US Low
UK Medium
Europe ex UK Low-medium
Japan Medium
Emerging markets Medium-high
Fixed income US treasuries Low-medium
Euro treasuries Low
UK gilts Low
European credit Low
High yield Low-medium
Emerging market debt Medium-high
Others Real estate Low
Sterling Medium-high

In general terms, developed equity markets tend to look richly valued at present. In the US in particular, price to earnings (P/E) ratios are at historic highs, profits as a percentage of GDP have reached record levels, and the dollar is strong against a Brexit-weakened Sterling, i.e. these three drivers of value over 2013 to 2017 have now become drivers of future risk.

UK gilt yields of around 1% over ten years are historically low. The traditional ‘risk-free’ asset class, gilts are now ‘return free’ in real terms, assuming inflation stays around the 2% target.  And government bond yields are similarly unattractive in other developed markets too. 

There are pockets of value, however.  The last five to ten years have seen emerging markets’ relative values decline. Yet the International Monetary Fund still expects emerging markets’ aggregate Gross Domestic Product to grow by 4-5% annually over 2017 to 2019, and these markets could offer the discerning investor superior opportunities to developed ones.  As ever with emerging markets, the outlook overall is likely to cover significant variability at regional and firm-specific levels, and volatility will continue to exceed that of developed markets.

Advisers may want to urge their clients to be more cautious now than they were over 2014 to 2016.  Even with low rates, it may be the time to raise cash weightings and de-risk aggregate asset allocations. Sterling could be the big surprise over the next 12 months.

These are Aegon’s views based on market and political indicators as at July 2017. They shouldn’t be relied on as an indicator of future performance. The value of investments may go down as well as up.

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