The results show that US sectors (not surprisingly) are most sensitive to higher US real rates given its equity structure and the proximity to its domestic bond market. Other central banks are also in the process of raising rates, like the UK and possibly the ECB by the end of the year. So this analysis also highlights some other non-US sectors that are vulnerable to US rates. These include Europe ex-UK, as well as its consumer staples, consumer discretionary and IT sectors. Within the UK, industrials and utilities are also vulnerable, while it’s IT in emerging markets and Japan. Investors should be wary of their exposure to these areas of global market.
Macro risks from higher rates
Global equities started the year on a negative footing even before the Russian-Ukraine conflict. Before the invasion on 24 February, the MSCI All Country equity benchmark was down nearly 9% in GBP terms likely due to investor uncertainty about rising US rates. Provided higher rates do not stall the economic expansion, less rate sensitive value-focussed equities (e.g energy, materials and financials) are well placed to recover from trend GDP growth and pent-up demand from the pandemic fuelling the consumer recovery. Nevertheless, there are two key macro risks for investors to monitor.
1: Debt burden on the economy – Higher interest rates raise the cost of borrowing and therefore leave less money to be spent elsewhere, whether that is by governments, consumers, or businesses. This has the potential to reduce economic growth.
Undoubtedly, aggregate debt burdens are higher, particularly after the pandemic. However, debt build up since the Global Financial Crisis has been focused in the public sector or debt backstopped by the Federal Reserve (such as corporate bonds).
In the private sector, households’ share of the overall debt burden has dropped significantly as a share of GDP, so that debt servicing ratios are at record lows. In the corporate sector, upward pressure on credit spreads should be limited due to elevated profit margins and low unemployment driving growth and profits sufficiently to meet debt payments. In short, higher rates for the private sector (in aggregate) are not really an issue at historically low interest rates.
2: Pace of Fed rate hikes – for the time being, Federal Reserve rate hikes have been well-signalled in money markets. The risk is that interest rates need to rise faster than expected. However, we believe the Federal Reserve won’t want to dent the nascent economic recovery by becoming too hawkish and particularly given the geopolitical uncertainty from the Russian invasion of Ukraine.
In summary, we expect US rates to continue to rise over the next 12 months at least. Considering that this new monetary policy environment changes the landscape for investors and the balance of risk and opportunities, we would focus on those markets and sectors that have historically been less rate sensitive, which we anticipate being relative outperformers. “Don’t fight the Fed” has been a successful mantra for investors in the past. This is likely to ring true again in the coming months.
