Macro-economics and your portfolio
Published: 6 January 2017
As the big political events of 2016 unfolded, there was vast speculation over what they might mean for stock markets.
In the end, meltdowns failed to materialise on the back of the EU referendum and US elections, but the impacts that both events had on bond markets, currencies and monetary policy were widely felt.
For investors, this provided a reminder of how various economic and monetary levers interact with each other.
Macro-economics is the bird’s eye view of things, making sense of the economic system as a whole. But where do you begin when it comes to pulling it all together? Interest rates are a good place to start, given how they affect everything from borrowing costs and spending decisions to exchange rates and asset values.
In December, the US Federal Reserve opted to raise interest rates for only the second time in a decade. However, UK rates were left unchanged by the Bank of England’s Monetary Policy Committee (MPC), which is tasked by the government with using interest rates and other economic levers to hit an ongoing inflation target of 2%.
While monetary policy isn’t designed to directly affect the interaction between things like asset prices, investor risk appetite and asset price volatility, the relationship between them is a close one. If prices are rising too quickly and the Bank is concerned that inflation could overshoot the 2% target, interest rates can be raised to try and slow the rate of growth in prices.
Interest rates and equity returns
UK interest rates have, since the 2008 financial crisis, fallen to a recent record low of 0.25% as the Bank has sought to boost economic activity by keeping borrowing costs low (for both businesses and consumers). This low interest rate environment has helped equity investors, as relatively speaking, equity returns are generally higher when interest rates are low.
One reason for this is that with low interest rates pushing down returns on both cash savings and bonds, people are more likely to take the risk of investing in equities. Another is that low interest rates generally help firms by reducing their borrowing costs and so making it easier to pay dividends to shareholders. Dividends aren’t just a source of regular income, but when reinvested can also make a large contribution to long-term returns.
The reverse applies too, as equities generally - but not always - underperform compared to other asset classes when interest rates are high. This is partly because higher interest rates reduce investor appetite for risk and also because it’s more expensive for companies to borrow.
However, the time gap between interest rates being increased and stocks and shares being dragged down by them can be a long one. This is thought to reflect the belief among investors that economic growth will be sufficiently robust to cope with the effect of high interest rates.
Interest rates and bond prices
Interest rates have a different impact on bonds, the prices of which tend to go in the opposite direction to interest rate movements.
There are two main forms of bonds - corporate and government. The former are issued by companies to raise money from investors in return for interest payments. They generally pay more interest than government bonds, as the risk of the issuer defaulting is higher.
Both government and corporate bonds have benefited from interest rates being low, as the interest rates they offer can look more attractive compared with other assets, leading prices to rise. Conversely, of course, rising interest rates are usually bad news for corporate and government bonds, leading prices to fall.
Higher interest rates might also suggest to investors that there are greater risks ahead for the economy, further reducing the appeal of investing in company debt.
It was the effect of Brexit on UK government bonds (gilts) that particularly caught the eye in July 2016. Demand for gilts rose sharply as investors concerned about the impact of Brexit on the UK economy bought them as a ‘safe haven’ holding. As their price went up, yields went down - and that had broader implications.
For example, the yields on 15-year UK government bonds are often used as the basis for the pricing of both annuities and final salary pension payouts. Those yields fell to record lows after the referendum, sending annuity rates in the same direction and causing problems for the defined benefit (final salary) pension funds that buy large amount of gilts as investments.
How does property fit in?
We’ve looked briefly at the interaction between interest rates and equities and bonds, as well as the role played by government bonds. But where does property fit into this?
As a sector, property tends to benefit when interest rates are low, as investors and borrowers take advantage of low mortgage costs. Conversely, high interest rates are typically bad news for borrowers and property investors as costs increase.
The role of quantitative easing
Interest rates aren’t the only monetary tool available to policymakers. The financial crisis saw the Bank of England (and other central banks) turn to quantitative easing (QE) in a bid to prevent a deeper downturn. At its most basic, QE is when new money is created electronically to buy assets such as government bonds from pension funds and insurers.
The idea is that injecting more money into the system encourages institutions to lend, in turn keeping interest rates down, reducing volatility and incentivising investment in risky assets.
The Bank has other tools at its disposal too, such as the ability to adjust the amount of capital it requires financial institutions to hold.
As the past few years have underlined, however, the interaction between the main asset classes and the different levers that the Bank of England (and other Central Banks around the world) can pull ensure that even seemingly arcane policy decisions can have far-reaching implications for savers and investors.
Diversification is key
The different ways that assets can be affected by changes in interest rates, quantitative easing and other key economic influencers – like currency rates, for example - is one of the main reasons for long-term investors to have a well-diversified portfolio.
Being diversified generally puts you in a better position to be able to consider leaving things alone, riding out any short-term volatility caused by changes in the macro-economic environment. You’ll still have the option to research and take advantage of any specific short term opportunities that may be a match for your investing objectives and appetite for risk.
Important informationThese articles are designed to help investors make their own investment decisions. They do not constitute a personal recommendation to invest. If you have any doubts as to their suitability you should seek expert advice. Please be aware that the value of investments can fall as well as rise so you could get back less than you invest.
Your existing pension may have valuable benefits which you might lose when you transfer.
Laws and tax rules may change in the future without notice. The information here is our understanding in January 2017. This information takes no account of your personal circumstances which may have an impact on tax treatment.
Past performance is not a guide to future performance.