Investors in banks and tech companies could make money as rates start to rise, but telco and bond investors might lose out.
Rising interest rates are changing the rules of the game for investors. Over the last decade, investors have largely been operating in an environment of record low interest rates – but these days are now coming to an end. European interest rates are expected to increase at some stage next year. Although it could be well into 2019 (if they do), any rate hike next year would be the first rise in almost seven years and most likely the beginning of a series of increases.
Interest rates have been rising in the United States since December 2015. The US central bank, the Federal Reserve, raised interest rates there three times in 2017 – and is expected to do the same again, or more, in 2018. British interest rates were increased for the first time in 10 years last November – and many expect the next rate hike there to occur this May.
So should stock market investors be worried when interest rates head upwards?
Interest rates are typically increased when the economy is improving and inflation is rising. As long as inflation isn’t rising too steeply, equities typically do well, according to Brian O’Reilly, head of global investment strategy at Davy Private Clients. “Equities have a sweet spot when inflation is rising – though companies don’t like deflation or hyperinflation,” said O’Reilly. “Equities generally do well when inflation is between 1pc and 5pc. An improving economy translates into corporate profits and that typically is good for equities.”
There is, however, likely to be further stock market volatility this year as interest rates rise because higher interest rates put many heavily-indebted companies under pressure, added O’Reilly. “Investors will factor in the inability of companies to borrow at zero pc interest anymore,” said O’Reilly. “A lot of ‘bad’ companies can remain profitable when interest rates are zero but as interest rates rise, these companies will go out of business because they can no longer fund themselves. So there will be casualties of rising interest rates.”
Shares with promise
So which shares are likely to do well as interest rates rise?
“The companies which typically do well when the economy is growing and interest rates are rising include the companies which don’t rely on any debt at all – such as technology companies,” said O’Reilly. “Many tech companies are practically immune to rising interest rates and benefit from economic growth.”
Some tech shares which could do well amidst higher interest rates include the likes of Intel, Cisco and Alphabet.
Banks also typically do well when interest rates increase because they can lend money at much higher interest rates – which improves their margins and by consequence, usually their profits. (A bank’s margin is the difference between the amount of interest it earns from money it has lent to borrowers – and the amount of interest it pays on its own borrowings).
So the shares of US banks such as JP Morgan or Bank of America could be worth snapping up or holding onto. So too could the shares of US trust banks such as Northern Trust. Many insurers also benefit from higher interest rates and so US life assurers such as MetLife and Prudential Financial, and the multinational insurer, AIG, could do well.
Shares in major European banks could be worth snapping up ahead of 2019 – as the major European banks are likely to be beneficiaries of any increase in ECB rates. Big insurers, such as Allianz and Zurich, could also benefit.
Vulnerable shares
The shares of telecommunications and utility companies are typically vulnerable to rising interest rates as these companies often fund themselves with high amounts of debt, according to O’Reilly. So some US telco and utility companies could come into pressure this year – and investors in these could see their shares lose value as a result.
“European telcos and utilities would also be at a disadvantage,” said O’Reilly.
Investors with shares in big cap US companies could also start to lose money because many of these companies also have a lot of debt and so will be vulnerable to rising interest rates, according to Peter Brown, co-founder of the Dublin firm, Baggot Investment Partners. (Big cap companies are typically those with a market capitalisation of more than $5bn). “It is the big cap US corporates who have borrowed a lot of cheap money – so this sector is very exposed [to rising interest rates] and could get hit very badly,” said Brown.
Many of the off-the-shelf equity-based products available in Ireland have a lot of exposure to big cap US companies, warned Brown. So should you have your money invested in a pension, investment fund or life assurance policy offered by an Irish provider, check how much of your money is invested in big cap US companies.
Should you have money in a product which is heavily invested in big cap US corporates, ask an independent financial adviser if you should reduce your exposure to that sector.
Investors in bonds also need to be careful.
“As interest rates go up, it’s typically not a good [investment] environment for bond investors – especially long-dated bonds,” said O’Reilly. “However, short-dated bonds are less sensitive to rising interest rates than long-dated bonds.”
A short-dated bond is typically one which matures within or before five years. Long-dated bonds have much longer investment terms – typically maturing over anything from 10 to 30 years.
Inflation-linked bonds and convertible bonds could however do well as interest rates rise, according to Brown. These bonds typically offer investors some protection against inflation.
Savings v shares
Although rising interest rates will lead to higher mortgage bills for many Irish borrowers, savers should benefit as banks generally increase the interest paid on deposit accounts when rates go up. “With rising interest rates in the US, if you live in the US, all of a sudden you can get a 2pc to 3pc return on your deposits,” said O’Reilly. “Europe will follow. In-between two and three years’ time, you may be able to get 2pc interest paid on savings accounts in Ireland.”
Over time however, the returns on shares are likely to beat those made by deposit accounts, according to Eoghain Murphy, director at the wealth and investment management division of Barclays in Ireland. “With the prospects for economic growth still looking firm, and signs of overheating still substantially absent, in our view, shares continue to offer the most attractive returns,” said Murphy. “Expectations are that corporate profitability will continue to surge.”
Industrial, technology and financial businesses and the regions most heavily dominated by those types of businesses – such as Asia, the US, and Europe (but not including Britain) – are cited by Murphy as “the most interesting” sectors for equity investors.
It’s important, however, to take a long-term view.
“Being invested across a diverse set of assets – such as stocks, bonds, alternative trading strategies and commodities – is generally going to provide you higher inflation-adjusted returns than you will receive from your bank account,” said Murphy.
“The further into the future you are happy to look, the less you need worry about calling the next recession and the more you need to just put your cash to work and forget about it.”
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