Funds and stocks to buy as UK interest rates rise

The greatest financial experiment in history of ultra-loose monetary policy in the form of record low interest rates and quantitative easing is drawing to a close.

But rather than producing a big bang, the journey towards tighter monetary policy is expected to be slow and steady.

The consensus is that the recent rate rise to 0.5%, which puts borrowing costs back to where they sat before last summer's cut to 0.25%, hastily made following last June's Brexit vote, will not be swiftly followed up by further increases in the coming months.

When looking further ahead, however, depending on the health of the UK economy, whose fortunes hinge heavily on how the Brexit negotiations pan out, more rate rises could follow, particularly if inflation continues to rear its ugly head.

The majority of experts, though, are not convinced rates will rise more than once. Tom Becket of wealth manager Psigma Investment Management says rate rises against a backdrop of Brexit uncertainty and at a time when there are signs of a slowdown in the economy 'seem foolish'.

Others point out that Carney is simply once again playing the 'boy who cried wolf' -talking up the prospect of further, albeit 'very gradual' interest rate rises, in order to gain sterling support from financial markets, which in turn will help to keep the lid on inflation.

But even if you are a sceptic, a bit of forward planning to prepare for the prospect of higher rates is worth considering. Below we take a look at how investors can position their portfolio with a view to both protection and profit.

How to protect

Bonds, which have thrived in the low interest rate environment, look the most vulnerable asset class on paper.

When rates rise, bond yields will also head higher, resulting in capital losses for bondholders, as when yields rise bond prices fall (prices and yields have an inverse relationship).

Government bonds, perceived to be the safest type of fixed income holding, are highly prized and as a result carry expensive valuations and low yields to boot, with 10-year UK government bonds offering a yield of 1.31% at the end of October.

In the event of further rate rises, 'quality' bonds look anything but safe, notes Becket.

"The yields on offer are paltry and massively skewed to the downside. To put numbers on it, if market bond yields were to get back to historical levels, then investors could be looking at a 40% capital loss from a generic bond fund. We believe this sort of move to be highly unlikely, due largely to the low-growth world we are in, but do think a 20% loss is conceivable," he says.

Strategic bonds funds, which have the flexibility to invest in any type of bond, are viewed as the best port of call to protect investors' capital.

Other fund types are restricted to buying a particular variety of bond or those issued in a certain region, restricting their ability to choose bonds that are less susceptible to interest rate rises.

Adrian Lowcock, investment director at multi-manager Architas, favours Artemis Strategic Bond and MI TwentyFour Asset Management Dynamic Bond.

Not everyone, however, is convinced. Andrew Merricks, head of investments at financial adviser Skerritt Consultants, thinks strategic bond funds should not be viewed as a 'silver bullet', particularly when bond funds could suffer from a liquidity squeeze. Merricks is in the 'lower for longer' camp; but he says that under a worst-case scenario of rates rising too quickly too soon, the prospect of bond funds moving to suspend trading cannot be ruled out.

"In theory strategic bond funds should weather the storm better than others; but if there's a rout on the bond market, investors should not make the mistake in thinking strategic bond funds will be able to shield their capital - they will lose money," he says.

On the equity side of the equation, shares that are expected to suffer in a rising interest rate environment are those that carry expensive price tags - most notably those shares deemed to be bond proxies, including consumer goods and utilities.

"Highly rated equities would be the first to suffer from a tightening in monetary policy," notes Jeff Harris, co-manager of the Strategic Equity Capital fund.

The same sentiment is echoed by Joseph Bunting, manager of the Tellsons Endeavour fund.

He adds: "Quality growth stocks are in a bubble, but when rates rise those who have turned to bond-like shares will look to put their money elsewhere."

Outside of UK assets, the emerging market regions face a testing time given the prospect of more rate rises being implemented across the pond in the US; rates there have been moved higher twice already in 2017.

The textbook explanation is that higher rates hit emerging market regions and companies with higher borrowing costs on dollar-denominated debt, and also makes existing debts more difficult to service. As a consequence investor sentiment takes a knock, and money exits the region.

Ways to profit

Interest rate rises signal that all is well in the economy, and as a result banks, insurers, brokerages and asset managers should be among the winners, notes Lewis Grant, manager of the Hermes Global Equity fund.

He explains: "Banks, for instance, benefit from greater spreads on deposit accounts, while brokerages and fund managers typically attract more business as rising rates signal a strengthening economy and therefore greater investment activity."

His views are shared by Harris, who stands to benefit from rate rises due to his positions in Equiniti and IFG Group.

The former owns Selftrade, the stockbroker, while the latter owns SIPP provider James Hay. "For every 25 basis point rise in interest rates these two businesses will see a huge uplift in their profits," says Harris.

More generally, Bunting says he would be glad to see a gradual interest rate rise as it would move markets towards more normalised market conditions.

He adds: "Loose monetary policy in the form of quantitative easing has distorted financial markets, and I would welcome a more readily recognisable business cycle."

This would in turn lead markets to behave more rationally and be more focused on fundamentals, for example rewarding companies with highly efficient operations by enabling them to generate plenty of free cash flow.

Given that quality growth stocks are tipped to fall out of favour in a rising interest rate environment, this could also in turn result in a renaissance for value investing, which has been out in the cold for the majority of the past decade.

According to Tom Stevenson, investment director for personal investing at Fidelity International, if rates do rise more than once in the next year or so it will also be good news for investors exposed to cyclical sectors of the economy.

In such an event, Stevenson suggests, two funds well-positioned to profit would be Franklin UK Smaller Companies and Fidelity Special Situations.

He says: "If the economy is expanding, investors will start to favour smaller companies, which tend to have a more domestic focus. Franklin UK Smaller Companies, managed by Richard Bullas, looks for hidden gems, defined as smaller companies which the rest of the market has ignored. Fidelity Special Situations, managed by Alex Wright took, focuses on finding unloved companies entering a period of positive change. Importantly, Alex holds more than a quarter of the portfolio in financials, including Citigroup and Lloyds Banking Group, both of which stand to benefit if interest rates rise."

But as ever, there's a big caveat to all these predictions, as if the outlook for the UK economy continues to remain challenged then the likelihood is that there will be just the one token rate rise that has already materialised. In this scenario bond proxies will probably continue to perform well.

Although the UK's GDP figures for the third quarter beat economists' forecasts, growing at 0.4% versus an expected 0.3%, the productivity puzzle is the biggest challenge that needs to be solved, given that output per hour of labour is no higher today than before the 2008 financial crisis.

Ben Brettell, a senior economist, notes: "Productivity is the key driver of economic growth. Improvements here are the only way real incomes and living standards can rise. But economists and policymakers can't agree on the cause, let alone the solution to the productivity problem."

Savers

Those with cash in the bank have now seen a decade of falling returns; but over the past couple of months there have been signs of life in the savings market, with various providers, most notably the challenger banks, raising rates and sparking some much-welcomed competition.

A single rate rise of 25 basis points will probably not make a big difference and rates will remain well below inflation, but it should lead interest rates on deposit accounts to nudge higher.

Borrowers

Mortgage deals linked to the base rate will rise immediately while borrowers on their lender's standard variable rate (SVR) are also likely to suffer. SVRs are not specifically linked to the base rate, but generally move in line with it.

Those on fixed-rate deals will be unaffected. But for those on the lookout for a fixed-rate deal or coming towards the end of an existing deal, the fixed rate option has become less attractive, because the market has already moved to price in an interest rate rise and mortgage rates have therefore been rising over the past couple of months.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.