Edd Gallus, associate global macroeconomic analyst at investment specialist OCM Wealth Management in Northampton, assesses how higher interest rates can affect investment plans.
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2022 was a difficult year for investors as geopolitical tensions and a strong rebound in consumer demand resulted fed through into elevated inflation expectations across key developed economies.
As headline inflation levels reached multi-decade highs, the Bank of England became the first developed economy central bank to raise interest rates in December 2021, going on to raise rates at 10 consecutive meetings thus far.
The US Federal Reserve looked to aggressively raise interest rates as they took the US base rate from 0.10% to 4.75% as borrowing costs reached the highest level since 2007.
We expect 2023 to be a tale of two halves, with stronger than expected economic data out of the US and Eurozone in January and February pointing to more work needing to be done in order to tame inflation. While January saw strong financial market performance as investors began to price in a pause in the Fed’s monetary policy tightening, a series of strong economic data dampened sentiment, weighing on fixed income and equity markets in February.
Our expectations remain for inflation levels to decline substantially as global inflationary pressure abate, with falling energy and food prices contributing to a decline in year-over-year comparisons, giving central banks the opportunity to pivot away from hiking interest rates.
Ongoing resilience in key developed economies is expected to support global economic growth, potentially boosting risk asset prices over the coming year.
As the long-term economic outlook begins to brighten, diversification will be key as investors look to benefit from a peak in interest rates. Following somewhat stronger economic data than expected, a key question remains whether developed economies could escape recession in 2023 as household balance sheets remain stronger in comparison to previous recessionary environments.
The recent collapse of Silicon Valley Bank has increased concerns surrounding the impact of the aggressive monetary policy tightening implemented by central banks so far. While the news unsettled investors, we do not believe this presents a systemic risk to the wider financial sector. SVB collapsing was as a result of significant balance sheet mismanagement , an issue specific to SVB and not a wider one.
Can Consumers Benefit from Higher Rates?
Typically, rising interest rates occur during periods of economic strength, meaning increased rates may coincide with strong equity market performance. However, given the risk of inflation becoming entrenched in the economy, central banks have been forced to raise rates far more aggressively following over a decade of ultra-low interest rates.
Whilst higher rates are a positive for consumer savings accounts which benefit from the increased rates of return on their cash, the benefits of this tightening cycle have been significantly outweighed as rising energy and food prices have resulted in a drop in consumer disposable income levels.
Mortgage rates have increased to their highest level since the 2008 financial crisis, further squeezing household balance sheets, which is preventing many consumers from benefiting from the increased savings rates.
Typically, a rising interest rate environment would be expected to weigh on global economic growth, feeding through into lower commodity prices, providing households with lower energy prices and cheaper fuel prices, further providing some benefits to households.
This is no Normal Tightening Cycle
This interest rate hiking cycle, however, is not a typical one, with the war in Ukraine restricting commodity and grain supplies, whilst the ongoing ban on Russian energy exports may result in a more costly refill of natural gas reserves in Europe. With inflation remaining above central bank expectations in many developed economies, interest rates are increasing as economies slow, with China’s rapid reopening set to support global economic growth moving through 2023.
Central banks are being forced to tighten monetary policy despite weakening economic growth, although excess savings built up during the pandemic are currently sheltering households as consumer spending levels show a level of resilience.
Uncertainty Leads to Volatility
2022 was one of the most volatile years in recent history as a result of geopolitical tensions and macroeconomic headwinds. Investors were left with few places to hide, as fixed income markets entered their first bear market in a generation whilst equities experienced significant declines, with commodities and the US dollar the best performing assets during the turbulent market conditions.
The difficulty for investors was highlighted by the performance of the 60/40 portfolio, which declined around 20% in 2022, meaning diversified long-term investors without active management strategies faced significant headwinds.
More cautious investors were hit hardest as gilt markets which were previously considered ‘low-risk’ declined sharply following former Prime Minister Liz Truss’ mini-budget and economic plan.
The rapid monetary tightening implemented by many central banks over the last year has forced investors to re-evaluate asset valuations which are tied to assumptions surrounding interest rates, with a re-rating of risks weighing on market returns in 2022.
Recent upside surprises in inflation data alongside strong economic data make this a less predictable environment than many had believed moving into 2023. Investors have moved to price in further rate hikes by the US Fed and European Central Bank in particular, which has weighed on financial markets in recent weeks following a strong start to the year.
Opportunities Moving Forward
While economic conditions remain challenging in 2023, it is our view that current market conditions present attractive opportunities for long-term investors. With equity markets reaching depressed valuations as key recessionary risks were priced in, this presents an attractive entry point for long-term investors.
European equities escaped a worst-case scenario as a mild winter fed through into a decline in natural gas prices, with ongoing economic resilience therefore resulting in a strong performance from European indices, with European equities up over 14% since falling to a yearly low in September 2022.
With interest rates expected to peak in the coming months, fixed income yields have become more attractive, offering a more attractive level of income in comparison to recent years whilst offering increased diversification and providing a level of protection during periods of negative investor sentiment should recessionary concerns grow as a result of the higher interest rate path laid out by central banks.
Looking ahead, while markets are likely to remain volatile in the short term, we are cautiously optimistic on market returns over the year. For this reason, the themes which we see as being key to navigating markets over the year are active portfolio management, diversification, quality and yield.
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