With interest rates at record lows for the last two years, it is difficult to imagine a scenario when we will be back at normal levels. However, while rates of 5 per cent may still be some time away, it is clear we are moving closer to an increase.
The recent drop in inflation may have put off interest rate rises for a while but it is still likely they will start to rise later this year. The Bank of England estimates inflation will be down towards 2 per cent by the end of 2012 while interest rates are predicted to be above 2 per cent at this point, rising further thereafter.
In a recent survey, 86 per cent of financial advisers questioned said interest rates will rise over the 12 months. The most common estimate for interest rates in one year’s time was 1 per cent but a significant number believe they will increase to 1.5 per cent to 2 per cent.
Interest rate moves impact almost every asset class but some are more effected than others, so it is important to get your asset allocation right as we move into this next phase.
Rising interest rates should be good for equities on this occasion. A hike in rates indicates the spectre of deflation has disappeared and the global economic recovery is well under way. With this backdrop, equities in higher growth regions such as Asia and emerging markets should outperform.
A rise in rates will impact on capital values but investment-grade bonds will remain more attractive than government bonds against rising rates. The caveat to this is if rates rise much faster than expectations, in which case this would be very bad for fixed interest.
Given the strong correlation to equities, high-yield bonds are the area of the bond market least impacted. An improving global outlook makes the risk/reward trade-off appealing for high-yield bonds at this stage of the cycle.
In a normal environment of rising interest rates, investors would be fearful of a global slowdown that would be a concern for commodity prices. However, after the financial crisis, when prices got hit hard, the strong global demand for commodities should outweigh any concerns over the impact of higher rates.
Risk appetite is increasing as the global economic recovery takes hold. Rising rates will attempt to make government bonds more attractive given the increase in yield but the yield uplift available in other asset classes makes these assets unattractive. Rising yields will also dent capital values.
With inflation high, cash is still generating significant negative real returns for investors. This is likely to remain the case for some time, given the low levels of interest rates right now.
Ryan Hughes is head of multi-manager at Skandia Investment Group