16 June 2015

David Cameron confounded sceptics in May to secure an overall Conservative government majority. Commentators have highlighted the obvious parallel with John Major's surprise win in 1992, when the consensus had also proved to be 100 per cent wrong. But is there another parallel with the events after the conservative victory in 1992? The afterglow of John Major's victory proved to be short lived as a failing economy and unsustainably high interest rates - close to 10 per cent - caused Britain to crash out of the European Exchange Rate Mechanism (ERM). The effect on the economy and the stock market of this sudden change in interest rate expectations was profound.

The prevailing view that interest rates would remain high proved to be wrong in 1992. Could the current consensus view that interest rates will remain low prove equally wrong today? In many ways today's environment is a mirror image of 1992: the ERM exit and fall in interest rates proved to be the catalyst for renewed vigour in the economy and the stock market, whereas a sharp increase in interest rates from today's level could have the reverse effect.

Inflation and interest rates

While the parallels to 1992 may be interesting, the reality is inevitably more complex. There are three points that seem pertinent: the inflation environment, the progression to more normal interest rates and the pace of this interest rate movement.

The main difference in today's environment is the inflation backdrop. UK inflation is close to zero and even if the short term depressant of low oil prices is stripped out, it remains subdued. Globalisation, ageing demographics, overcapacity in many sectors and the deflationary impact of technology and the Internet are structural factors which should anchor inflation at low levels. This is the most important driver of interest rates.

What is back to normal?

It is also important to draw a distinction between moving from zero interest rates to something more normal, rather than the levels seen at times of higher inflation. A rise in interest rates, to say 2 percent, is actually a healthy development and a sign that economies are moving away from a period of extreme distress. It's important not to be overly concerned about this move to a more normalised world.

The key uncertainty for equity markets is the pace of this interest rate increase: A measured and gradual increase is not necessarily negative for equities, but a rapid and disorderly rate increase is likely to cause unwelcome volatility. The market is currently pricing in a very slow and measured increase in interest rates, particularly relative to previous UK interest rate cycles.

Our response

Slowly but surely we are returning to a more normalised interest rate environment and we have been focusing on companies that should perform well as interest rates gently rise. These include financial shares such as Lloyds Bank, and companies where there is scope for self-help such as Rentokil and Carnival. We are avoiding those companies where valuations are dependent on ultra-low bond and interest rates, such as the utilities sector. As interest rate expectations increase going forward this is likely to mean higher levels of volatility. While investors understandably dislike volatility at a fund level, for a stock-picker it means price and valuation opportunities and we must be alert to ensure we take full advantage.

We may not be looking at a repeat of the dramatic ‘Black Wednesday' in 1992 which fundamentally changed the equity outlook overnight, but we are looking at a period of heightened volatility as the bond market adjusts to a more normalised world. Rather than relying on shares that have performed well in a world of low interest rates, a successful income investor for this environment will, we believe, need to have an open mind and the flexibility to take advantage of income opportunities right across the market. We see this as a great environment for income fund managers who are able to be flexible and dynamic.

CARS ref: RSM-119
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 16 June 2015 and may change as subsequent conditions vary.

The prevailing view that interest rates would remain high proved to be wrong in 1992. Could the current consensus view that interest rates will remain low prove equally wrong today?