As part of our quarterly investment reviews, we have been focusing on our general assumptions and thinking with regards to the wider economic environment. Our stance and approach has not changed since the inception of our portfolios in 2007, which is to use common sense, to not over complicate a solution and to only invest in instruments we understand completely. This approach has served us and our clients exceptionally well, avoiding costly mistakes in investments like Standard Life GARS and more recently Woodford Equity Income - where marketing, promotion and ‘star managers’ has masked the underlying lack of quality, risk and over complexity.
Nevertheless, it is important to actively challenge our assumptions and thinking - this is something we look to embed in our process. One factor that drives a huge amount of return is that of interest rates, with both equities and bonds reacting to changes in the UK Government’s base rates. Ever since the credit crunch, we have seen historically low rates and internally we have discussed the effects and potential timings of when they will rise? When will they return to normal?
The question we are now asking is, ‘What is the normal rate of interest?’
The past quarter has seen both the United States and Europe lower interest rates in fear of future slower growth. The much talked about “quantitative tightening” leading back to higher ‘normal interest rates’ appears to have stalled for the time being and the immediate outlook suggests that higher rates are some way off.
For the first time in a decade since the 2008 financial crisis, the US Federal Reserve lowered interest rates twice in the space of three months. Although the US is enjoying its lowest unemployment rate since the 1960s, and the US Federal Reserve did state the outlook for the economy remains favourable, it was cautious about future growth prospects given the continuing US-China trade war. This is a clear change in rhetoric from the the summer of 2018, which intimated that interest rates were set to regularly rise, causing equity markets to fall sharply. Whilst the flip-flopping of such policymaking has helped markets to bounce back, this variable approach does add in a level of uncertainty and also makes us wonder about the sustainability of US markets returns.
Closer to home, in his final weeks as European Central Bank (ECB) President, Marion Draghi restarted its quantitative easing programme, with the buying of bonds and lowering of interest rates for banks to a more negative -0.5% from -0.4%. The region is still suffering from sluggish growth and low inflation, (its target is 2%) and this is not helped by US-China trade spats and uncertainty over Brexit. Will the ECB policy work?
Now on home turf as the collective nervous breakdown of UK politics continues, the next month will be interesting. Will the UK leave the EU without a deal at the end of the month? Will there soon be an election and what of its result? It appears that the incumbent Conservative government has announced an end to austerity and will up spending on popular themes such healthcare, the police and education. Moves that are regularly linked to election manifestos, but also often come with a positive effect on markets. However in times where Brexit and politics clearly run the show, it is unlikely we will see markets return to being linked to underlying economic factors until the whole Brexit debacle is resolved.
Returning to our question ‘What are normal interest rates?’, it would have been inconceivable in 2007 that the ECB would lower bank rates to a negative figure. The theory behind such a tactic is by effectively charging banks to hold money they will lend more and as such it will stimulate growth. Also, looking at the position of UK homeowners and borrowers, there does not seem much scope for a base rate rise, which could in itself push already strained corporate cash flows and mortgage cash flows into the red, with the knock on effect pushing us into recession.
As such, the old normal interest rates do not seem to be coming back anytime soon. Lower for longer is our expectation and whilst 50 is the new 30, 70 the new 50 maybe with interest rates 0.5% is the new 2.5%!
As part of this new series of more regular market updates we will look to continue to test our portfolios against the different benchmarks available reporting back when new updates are available. Each review we will look to go into depth about a single topic and so should there be any areas of personal finance or investment management that you would like to hear about please do not hesitate to contact us on firstname.lastname@example.org.