By Philip Matthews, portfolio manager, TB Wise Multi-Asset Income
Having surprised markets in November by not raising rates, the Bank of England has further surprised markets at its December meeting by now choosing to increase them by 0.15% to 0.25%. Market expectations of a rate rise had fallen to about 20% prior to today’s decision given the near-term uncertainty over the impact that the Omicron variant might have on economic growth.
While the Bank of England risks being labelled an unreliable boyfriend as a consequence of its poor communication around this rate rise, there is little surprise that interest rates were set to rise from the emergency levels imposed immediately post the onset of Covid.
The surprise therefore is more around its timing rather than the fact interest rates have been increased. With UK GDP forecast to increase by nearly 5% in real terms next year, inflation expected to touch 6% and unemployment at just over 4% pressures have been building for ultra-loose monetary policy to be tightened.
This is not just a UK phenomenon, with the US Federal Reserve also dramatically shifting their projections for the direction of interest rates overnight. It now forecasts three interest rate rises next year and a doubling of the pace of tapering its bond purchase programme (quantitative easing).
Both bond and equity markets appear to have taken the news in their stride, apparently fearing a decision not to grapple the inflation nettle might cause more long- term harm to the economy than focussing on the short-term uncertainty around Omicron.
While each successive wave of the virus has had a more limited negative impact on economic growth, inflationary forces are proving more persistent than initially expected and action was needed to stop inflation expectations feeding through to higher wages as well as to curb speculative behaviour in markets.
The subdued reaction in longer dated US and UK government bonds, which have barely moved on the news and sit below the levels seen in 2019 pre-Covid, suggests markets remain pretty sceptical over the ability of central bankers to tighten monetary policy significantly without it having a negative impact on the longer-term prospects for economic growth.
It is encouraging though to see central bankers make an initial step in tightening up financial conditions that risked encouraging over-exuberant behaviour. In addition to today’s rate rise it is also noteworthy that banks will be forced to hold more regulatory capital over the next couple of years (the counter-cyclical buffer) again reversing the action taken on the back of last year’s crisis.
Even though all UK banks passed an extremely penal financial stress-test earlier in the week, we welcome this decision to further increase financial stability in the banking system.
How to profit
We believe our portfolios are well positioned to perform against a backdrop of higher inflation and rising rates. We have a high allocation to equities, particularly to financials which are direct beneficiaries of rising rates.
Our commodity holdings, such as Blackrock World Mining, have benefited from rising commodity prices as well as continued capital discipline in the sector. Our infrastructure holdings, such as Ecofin Utilities and Infrastructure benefit from the structural transition of energy generation and have repositioned their traditional regulatory utility holdings towards countries whose regulatory frameworks incorporate inflation, such as the UK and Italy.
Our fixed income allocations are relatively low given the low yields on offer and the risk of higher persistent inflation. However, we do hold the Twenty Four Income Fund where the underlying asset backed security holdings are floating rate in nature and thus see their coupons move in tandem with rising rates. Our other fixed income holdings, such as GCP Infrastructure and Starwood European Real Estate also have an element of floating rate exposure.
Finally, our property holdings should be able to mitigate higher inflation. In certain cases, such as Impact Healthcare REIT, rents are directly linked to CPI, while in others we believe inflationary pressures on land and build costs are pushing rents higher, such as with Urban Logistics. Finally, we believe there is scope for rents to recover in a number of other property holdings as vacant space is relet or balance-sheets capacity is deployed in acquiring assets. This should allow the high income levels to grow faster than inflation over the medium term.
We recognise, however, we do not want to build a portfolio purely predicated on the basis economic growth remains strong and inflation proves more persistent than expected. Covid remains a real economic threat and deflationary forces in existence pre-Covid, such as demographics, high levels of debt and technology, have not gone away. We will retain a balance within the portfolios favouring those areas where we believe low valuations provide an element of cushion in the event expectations disappoint.