08 February 2016

Since the financial crisis, there has been a dichotomy in markets – if economic news worsened, markets would still strengthen as investors anticipated further monetary stimulus. The link started to waver when the Federal Reserve deferred increasing interest rate rises in October last year; the market let it be known that it would have preferred the central bank to take action. It has now become clear that – for the UK at least – that link is decisively broken.

Earlier in January, Mark Carney ruled out any imminent rise in interest rates, swiftly dispelling any lingering expectations that rates might rise in the near-term. He followed up when he appeared before the UK parliament by saying that Britain’s current account deficit was still a risk to financial stability, due to global instability and a potential ‘Brexit’, and there was a risk that an additional risk premium would be attached to UK assets as a result.

Bad news means bad news

Carney appears unequivocally to be supporting a ‘lower for longer’ interest rate environment. In the past, this would have pleased market participants, who would have welcomed another phase of loose monetary policy, but now it seems bad news really is just bad news.

This has an impact for investors. Although few market participants foresaw any rapid rise in interest rates, Carney had previously said that the case for interest rate rises would be examined more closely at the beginning of 2016, and many still believed a rise this year was in prospect. It makes any significant sell-off in bond markets less likely and suggests that bond yields can remain at or near their low levels.

Back to the bond proxies?

This has a knock-on effect on the equity market. In theory, the ‘lower for longer’ scenario should favour those stocks that have been seen as ‘bond proxies’. For example, utilities have proved relatively defensive in the recent market rout and our zero weight to the sector has hurt relative returns.

Equally, markets have also taken the slow growth implied by a ‘lower for longer’ scenario as a sign to sell off any stocks with a degree of cyclicality. Banks have been at the forefront of this1. They are seen as both cyclical and risky, given their recent history. It has also been a difficult period for larger companies. In the market sell-off, larger companies have been used as a source of liquidity as investors have reduced their equity exposure2.

A more nuanced interpretation

However, while the market’s response seems understandable in an environment where global growth seems precarious, we would argue that the market’s response neglects both the longer-term growth prospects of some well-placed companies, and the valuation differential between companies. On the banks, for example, we believe low price to book valuations and strong balance sheets should prove protective3. With regulatory pressures easing and capital positions improving, in many cases what is left is simply a rather boring, retail bank. As a result we think banks will likely prove more defensive than the market is expecting.

Equally, we feel many larger companies are trading at relatively attractive valuations after a long time out of favour with investors. The ‘lower for longer’ scenario does not change this and we are not tempted to shift our positioning.

Investors should remember that lower interest rates do not equate to a full-blown recession. We expect an ongoing period of low nominal growth, which means lower profit growth, low and volatile bond yields and ongoing dispersion between winners and losers. We believe our approach should thrive in this type of market – and that the sell-off is providing opportunities to buy into good companies at lower prices – but it’s clearly going to be a bumpy ride this year.

CARS ref: RSM-3041

1European banking sector has fallen 9.04% for YTD, compared to a fall of 2.89% for the wider European market. Source: MSCI 1 January to 29 January.
2Source: BlackRock, January 2016
3Source: BlackRock, January 2016

We feel many larger companies are trading at relatively attractive valuations after a long time out of favour with investors