Jamie Clark

Job gains mean higher rates are coming

Jamie Clark

Guess what? Interest rates can go up, as well as down.

This was the strikingly clear and somewhat obvious import from the text accompanying the Bank of England’s unchanged rate decision yesterday.

Why then did markets react with surprise to such an apparently uncontroversial message? Why should UK equities sell-off and gilt yields move higher?

Simply put, because the present zero interest rate environment has turned many investors into nothing more than ‘tailgaters’; an expression coined by economist and FT columnist John Kay to describe the tendency of some to hug prevailing markets trends, however stale, in expectation of further incremental gains, or yesterday’s successes repeating themselves.

This trend-hugging is leading shares to be mispriced, and we have several key Macro-Thematic exposures which seek to exploit this. The Funds are positioned to gain from the normalisation of economic conditions. Broadly, they have a value tilt and we would expect value to outperform both ‘bond-proxies’ and growth stocks under conditions of monetary tightening and higher discount rates.

Thematically, we are Avoiding Tobacco and Avoiding Utilities – two classic bond-proxy sectors – and we are also steering clear of consumer staples stocks driven to unsustainable multiples by investors’ appetite for defensive growth.

By contrast, the sizeable UK life insurers component of our Demographics theme stands to benefit from higher real rates. These stocks are currently cheap relative to the market, reflecting the pressures that low rates exert on liabilities and investment returns. At a stroke, higher rates could mitigate these pressures and trigger a more positive appraisal of the sector’s merits.

There have, however, been several monetary tightening ‘false alarms’ over the last few years (2013’s Taper Tantrum, the threat of an inaugural US hike in September 2015 and November 2016 election of Donald Trump), only for central bankers to lose resolve and rein in their hawkish intent. This has only served to entrench investor behavioural biases – evidence of recency bias and the availability heuristic seen clearly in investor’s ongoing attachment to low-rate beneficiaries – and amplify market distortions – the absence of yield in income markets forcing yield tourists to pursue equities with bond-like characteristics (i.e. tobacco, utilities and consumer staples).

So why should things be different this time? Why should tailgating the low rate trend cease to be profitable and what could make central banks change direction? 

The simple answer is that the economic recovery of the UK and other Western economies no longer makes depression-era monetary policy appropriate. Wednesday’s labour market data showed the UK unemployment rate hitting 4.3% in July – a 40-year low (see chart below) – below the 4.5% rate at which the Bank of England estimates inflationary forces are in check. 

Unemployment rate (aged 16 and over, seasonally adjusted)

Unemployment rate (aged 16 and over, seasonally adjusted)

Source: ONS

Naysayers may counter that muted UK earnings growth and the temporary effect of sterling depreciation on UK inflation count against the need to hike rates. But this somewhat misses the point. The Bank employs a Philips Curve framework (unemployment rate x, implies inflation rate y) and under such analysis, employment growth must eventually erode slack and stoke inflationary pressures.


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Friday, September 15, 2017, 2:20 PM