Interest Rates & Inflation: Is Your Portfolio Ready?

Here I explain what I will be buying, holding & selling when interest rates do begin to rise.

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Interest rates and inflation have been among the defining issues for investors throughout 2015, while more recently the prospect of a hard landing in China has also re-emerged as a key theme.

Some say that central banks are unlikely to raise interest rates any time soon because of weak price pressures, and also the potential for “second round effects” from weak oil prices to prove a further headwind in terms of inflation during the coming quarters.

Others have persistently advocated a rethink in terms of portfolio strategy, favouring a view that the improving outlook for wages, tightening labour markets and healthy consumption all suggest that a rate increase could still be on the cards in the UK and the US for the months ahead.

I fall into the latter camp. Most central bankers have always dismissed oil price-induced disinflation as a “transitory” phenomenon, in favour of the belief that, with core inflation measures (ex food and energy) still close to 1% in the UK & US, the respective economies are not as weak or fragile as headline measures suggest.

Furthermore, if we assume that energy prices have fallen as low as they are likely to go, then it becomes possible that headline inflation could now begin to turn positive quite naturally as early as next year.

With this, and a policy-maker’s two year time horizon in mind, 2% inflation no longer appears to be quite as far off.

Looking ahead, I believe firmly that central bankers in the US will look to raise rates before the year end, with the Bank of England probably following suit shortly after and for this reason, a rethink in terms of portfolio strategy would be well advised for many investors.

Buy and hold

In the FX sphere, long sterling and long USD dollar positions, relative to the euro and the Japanese yen, continue to look attractive. However, holdings within the European and Japanese stock markets markets may need to be reappraised.

In general, but particularly in relation to London markets, rising rates will mean that investors now need to be a lot more selective in regards to the shares that they buy.

I advocate looking to buy those companies whose underlying businesses will actively benefit from rising interest rates.

Such companies can be found in the general insurance sector — eg, Hiscox and Beazley — as well as in the banking sector, where some who still have large securities trading businesses could also benefit from the side effects of tightening monetary policy — eg, Barclays.

In addition, investors could also look for opportunity among the small circle of inter-dealer brokers who are listed here in the UK – eg, ICAP and Tullett Prebon — as it is these companies that have been among the hardest hit by the era of ultra-low interest rates, low volatility and generally depressed trading conditions.

No, Mr Bond

Bonds will obviously be an area to avoid in many cases, particularly where investors are unable to hold until maturity.

However, I would advocate that investors also steer away from those companies who have large piles of debt on their balance sheets, as these businesses could find rising finance costs difficult to contend with, particularly where such businesses operate within industries that are already facing challenges.

Utilities companies are a case in point. With ultra-low interest rates and steady revenue streams having supported attractive dividend policies during recent years, the sector has been a darling for income investors.

However, such firms are now grappling with lower energy prices, large investment commitments, regulatory pressures over the prices charged to consumers, and generally swollen balance sheets.

When considering that many of these companies have little more than 1.5x dividend cover — indeed, some have even struggled to top 1x cover in recent periods — it becomes apparent that rising interest rates could be what kills off the utilities sector as a theme among UK investors. For me personally, this sector will be an area to avoid  for at least the foreseeable future. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Skinner has no position in any shares mentioned. The Motley Fool UK has recommended Barclays and Beazley. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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