I am taking the upcoming Olympics in Paris as an incentive for me to start running again! Similarly, in the new landscape of higher interest rates, the entire psyche of investing needs to be reconsidered: It’s a bit like trading in our comfy slippers for running shoes – the pace has picked up, and we all need to stay on our toes. As rates are set to stay elevated, investors need to adjust to this more demanding financial environment.
Five years ago, it was easy to assume that rock-bottom interest rates would stick around forever, and low mortgage payments were almost taken for granted. However, after years of hiking rates to help rein in inflation, attention is turning to how quickly and easily central banks can reverse this course.
Last month Canada became the first country in the G7 to cut rates, soon followed by the ECB, with both indicating that inflationary pressures were subsiding.
Then came the news out of the US last week that the US Consumer Price Index came in below expectations in June, which reignited discussions of rate cuts by the Federal Reserve.
It’s little surprise then, with CPI inflation in the UK falling below the Bank of England’s 2% target, that all eyes are on whether we will follow suit. However, while circa 5% interest rates might seem uncharacteristically high, especially given the sub 1% levels we have been used to since 2009, it’s our belief at St James’s Place (SJP) that these current rates are a step towards what we are calling “new (old) normal”.
See more: US CPI sparks rate cut discussion after downside surprise
In other words, while we do agree with market expectations that several central banks will start cutting rates this year, a return to those near-zero interest rates is extremely unlikely. Part of this is down to longer-term demographic trends, where developed market economies will see falling birth rates and increasing longevity on the road to 2030.
We also expect to see age-related spending to increase while the tax-base declines, which will place upward pressure on government borrowing costs. Our outlook, therefore, is not just higher for now, but higher for longer.
Given interest rates are a fundamental factor influencing various asset classes, adapting to this “new normal” of higher rates is set to present both challenges and opportunities to advisers. Understanding how they impact different types of investments over the long term can help them navigate client conversations and recommend the most appropriate solutions.
The importance of adviser guidance is further highlighted in a year in which UK government spending per person is projected by the Office for Budget Responsibility (OBR) to only just keep pace with inflation, leaving the responsibility of personal wealth growth to fall on the individual.
The impact on equities
As the largest driver of marginal risk for most portfolios, understanding the implications of higher rates on equities is key. Historically, elevated rates have been associated with higher, not lower, equity prices. This is because higher rates often coincides with higher levels of economic growth, which can be beneficial for company profits.
However, the “new normal” could mean that investors can expect greater volatility for equities going forward. No matter the pace or degree of cuts moving forward, the focus for us is on opportunities in both rising and falling rate environments rather than being fixated on the next move by central banks. This means diversification across various sectors and regions remains a key focus.
Boost for bonds?
A question on the lips of many investors is whether this new environment could finally mean that ‘bonds are back’. Interest rates have a big impact on bond yields. When rates are high, bonds come with higher yields because they need to be attractive enough for investors to buy them.
If rates are expected to stay higher for longer, then the yields on existing bonds are likely to remain relatively appealing for a while. This marks a welcome shift from recent years when lower rates made bonds less appealing.
See more: What will the Labour government mean for UK bond performance?
As a result, we believe bonds can once again provide effective diversification, offering predictable returns and less volatility compared with other investment types. From a multi-asset perspective, current global bonds yields of 4% look more attractive in portfolios.. Further,on a five-year basis, this starting level for yields has historically equated to 30% returns on average, rendering global bonds much more than simply a defensive holding.
This improved outlook is reflected in our latest portfolio allocations, where the investment team has increased weightings to sovereign debt within the SJP Polaris and InRetirement funds.
The role of alternatives
When it comes to building diversified portfolios, many investors are drawn to the appeal of so-called “alternative investments”, which can include assets such as commodities, private equity, private credit, property, and hedge funds. Some of these have a lower correlation with standard asset classes, while others, particularly commodities, can be effective hedges against inflation.
However, with bond yields becoming more attractive, the bar for incorporating alternatives into our portfolios has been raised. This is because the risk versus return on alternatives is not as favourable as it once was, now that bonds are now offering higher yields.
At the same time, while alternatives can provide diversification within portfolios, they also can come with liquidity constraints and other complexities.
Dash for cash?
On the surface, as interest rates are staying higher, cash may look compelling. However, rates have increased precisely because inflation is high, and inflation will erode the value of cash over time unless it produces a return which can outpace the rise in prices. Indeed, it is the real rate of interest which is important. This means that instead of holding cash, in order to achieve a higher rate of return, it is instead time to put cash to work.
See more: The diversification dilemma: Is 60/40 dead?
Long term focus
While the market might seem quite daunting given strong performance in recent years, there are exciting opportunities to be found in a range of areas, sectors and across asset classes.
As we navigate through this higher-for-longer environment, it is vital we remain disciplined and focused on our key investment principles. Attempting to predict short-term market movements or reacting to news and opinions can lead to costly mistakes. Instead, focusing on long-term objectives and adhering to sound fundamental principles will be crucial.
Adjusting to the new/old normal of higher interest rates might feel like switching into those running shoes – it’s more challenging, but the journey is worth it. With careful planning and a focus on long-term objectives, investors can succeed in this environment. So, let’s embrace the challenge – after all, every great race starts with the first step. Enjoy the Olympics!
Justin Onuekwusi is chief investment officer at St James’s Place
