THE GLOBAL financial crisis erupted around a decade ago but while economic growth rates are back at pre-crisis levels and inflation is starting to gather steam, monetary policy is only just taking its first steps back towards normality.
When the crash materialised in 2008, central banks across the globe slashed interest rates to historic lows and began printing money in an attempt to soften the blow.
The extent to which this abnormal monetary policy fuelled the economic recovery is up for debate, but there now appears to be wide recognition that the current level of policy is no longer required.
In fact, rates have already begun moving higher in the US, with the Federal Reserve citing strong jobs growth and rising inflation.
Europe is behind the US in the tightening cycle, given the eurozone crisis in 2012, but even here there is a move away from ultra-loose policy.
In the UK, the Bank of England raised interest rates for the first time in over a decade last November and recent comments suggest that more hikes are on the way.
So what can we expect from stock markets in an environment of rising rates? There are, as ever, some areas that are likely to benefit and others that could lag.
It would be easy to presume that shares across the board would fall in response to rising interest rates as companies’ borrowing costs would increase.
There are, however, both winners and losers from tightening monetary policy.
Starting with the losers, consumer staples, tobacco, health care, utilities and telecoms, which all have bond-like characteristics such as low, stable growth and high yields, have so far underperformed in Europe in 2018.
This could persist if rates continue along their current path.
On the flipside, we may see financial stocks outperform. Why is this?
For banks, their essential business is acting as a middle man between borrowers and depositors.
This means taking a cut of the differential in interest rates offered between those two groups of customers.
In very simple terms, at higher levels of rates, there is a larger pie to take a slice of.
Banks themselves also have large cash deposits and bond holdings which accumulate interest as rates go up.
Rates rising for the right reasons – that is, an increasing economic expansion – would also tend to mean that banks’ bad debts would start to fall rapidly as companies and individuals find it easier to stay cashflow positive.
For insurers, the case is slightly different.
In effect, an insurer gets to invest policyholders’ money in the period between charging them for a policy and paying out on claims.
This typically means that they will have large bond holdings.
Bond prices, meanwhile, will generally have an inverse relationship with interest rates.
While interest rates have been low since the financial crisis, bonds have enjoyed a prolonged bull run and yields have fallen to multi-year lows.
Insurers had done well during this period, but rates fell to such low levels that the income they could generate on new policyholders’ money fell to almost nothing.
This reinvestment yield is closely watched by investors because without it the business model of general insurers would start to break down.
If interest rates were to move materially higher in the medium term, it is likely that we would start to see yields creep up.
Prices would fall as a consequence.
Overall, we see shares as a good hedge against moderate inflation.
Companies can demonstrate revenue growth as inflation allows scope to raise prices a little ahead of actual cost increases and this in turn leads to expanding margins.
Higher interest rates should keep inflation from over-accelerating and this would allow shares to benefit from this effect.
Olly Russ is head of European income at Liontrust Asset Management.
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