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The impact of interest rate movements on financial markets

Last week, the Bank of England (BOE) declared that the bank rate was being raised by 25 basis points to 0.75 per cent from 0.50 per cent. This news made me think about one of the local investor’s primary concerns, that is, the current low interest rate environment and low yields and when will all this come to an end. However, many seem to underestimate some potential implications of rising interest rates on investments.

The current challenging economic environment is related to certain central banks opting for accommodative policy while others are considering tightening monetary policy – two diverse policies that, generally, affect investments in different ways. The BOE and the United States Federal Reserve (FED) have already announced a number of interest rate hikes. Analysts believe that the interest rate in the UK will reach the one per cent mark over the next three years while that of the US will already be two per cent by the end of summer.

The tightening of credit in Japan and the eurozone has commenced by the phasing down of quantitative easing, which is when a central bank buys large purchases of assets, primarily sovereign bonds, to inject liquidity in the economy.

In June 2018, European Central Bank president Mario Draghi declared that the QE programme, ongoing for the past three years, will be phased out by December 2018. He said the programme has succeeded in placing the inflation level close to two per cent. He has, however, announced that an increase in interest rates is not imminent and not before summer 2019.

The UK and the US have both decided on an increase of the base interest rate due to a reduction in unemployment levels, a steady wage growth, increased economic activity and an inflation rate, which in both countries, now stands at around two per cent. Interestingly, this time the sterling depreciated after the rate decision. In fact, in normal circumstances subsequent to a rate hike, the currency should appreciate.

One interpretation could be that investors may have concerns on the forward-looking guidance of the UK economy and potential hard Brexit in the horizon. Returning to the interest rate problematic, an increase should trigger a surge in yields in both government and high-quality corporate debt, leading to a fall in the bond’s market price. This is because interest rates and bond prices are inversely related. The largest decliners are generally those low coupon-long duration bonds. This happens because the existing bonds which have a coupon slightly over the current risk-free rate offered by banks will be the first to be impacted negatively with an increase of the latter. The long duration accentuates this fall as the investor would be ‘locked’ into a low coupon for a longer period.

Theoretically, if an interest rate hike is expected to occur imminently, bond yields will increase in order to match the perceived new benchmark interest rate or the so-called risk-free rate. Contrarily, however, an actual interest rate hike which is lower than market expectations results in a market correction which would push the bond and possibly certain equity prices back up.

An increase in interest rates is not imminent

It is a misconception that changes in interest rates affect only debt instruments. An increasing rate could impact a highly leveraged company negatively. As already outlined, the market does not wait for the actual interest rate change to take place before pricing it in but is all based on market expectations. An expected increase in operating expenditure may automatically hinder projected growth levels of different businesses – resulting in a fall in the respective equity prices. On a broader scale, negative sentiment may prevail and lead to the fall in worldwide indices. This gives rise to a ripple effect which could lead to other stock market falls.

It is interesting to note that an interest rate hike does not always affect a company negatively. In fact, some corporations which have high cash reserves like banks, do benefit from increasing interest rates. The primary source of income of banks and other financial institutions is that of loans. An increase in interest rates will undoubtedly result in higher profits, thus pushing the equity price up.

Other than investments in the traditional world economies, emerging markets have long been considered as an alternative investment opportunity. The periodic US interest rate increments impact this market negatively due to the so-called flight to safe haven. All high yield or sub-investment grade financial instruments are perceived as riskier assets. This risk is compensated for by the ‘additional’ yield being offered by such instruments. An increase in the risk-free rate lowers the spread and thus results in investors shifting their capital back to safer assets. This results in huge capital outflows which impact the value of emerging market assets negatively. As a matter of fact, the current increasing interest rate scenario has put more pressure on the central banks of emerging countries like Indonesia, Hong Kong, and Malaysia to increase their interest rates.

Where does all this leave us? There is no foregone conclusion. Interest rates movements have impacted financial instruments differently over the years. There have in fact been instances when bonds still performed well in periods of increasing interest rates. Even though historically, bonds and equities tend to move in opposite direction, both asset classes are desirable in a well-diversified portfolio. Bonds are deemed to be the safer asset class while equities are best equipped to yield higher potential returns in the medium to long-term. Nonetheless, all investments require an adequate investment time horizon for analysis. Being patient and not panicking is essential.

This article was prepared by David Baldacchino MSc Wealth Management (Edinburgh), B.Com (Hons) Banking and Finance (Melit.), DipFA, investment advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta on 2122 4410.

www.jesmondmizzi.com

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