Peak rates? Options for investors

The recent decisions by the US Federal Reserve (Fed) and Bank of England (BoE) to hold rates at the 5.25% range suggest that we might have seen the peaks. Now is the time to consider what to do when rates peak, given that some believe they will remain elevated for longer.

A panel of experts – Keith Wade, Chief Economist; Remi Olu-Pitan, Head of Multi-Asset Growth and Income; and Tom Walker, Co-Head of Global Listed Real Assets – offered their insights into the current situation in a filmed debate chaired by Stuart Podmore, Investment Propositions Director. These are their key observations.

Have interest rates peaked?

Keith Wade: It looks very much that they have and the principal reason behind that is the improvement in inflation. It has come down, and down quite dramatically across the world. In the US, inflation was about 9% a year ago; it’s now around 3%. In Europe, the improvement has been even more dramatic, down from about 10% to less than 3%. In the UK, it’s also come down quite a bit but it’s still around 4.5%, but that’s down from more than 10%, so it’s a big improvement. This has led people to think that the central banks have done their job and markets are now looking for rate cuts next year.

Keith Wade: Rates have peaked, but don’t expect them to come down quickly. For the US, we think the first rate cut will be in September next year. But we think rates could come down more quickly here in Europe. The ECB and the BoE are not just looking a lower inflation, they are looking at quite weak economic activity with a higher risk of recession. So, we think the ECB could cut as early as March and the BoE probably in May. So yes, we do think that rates have peaked but there’s going to be a difference in the speed at which they come down.

Is a peak in rates good news for investors?

Remi Olu-Pitan: The fact that inflation has peaked – and for the right reason, because inflation is coming down – is a good reason to celebrate. That’s certainly what financial markets are doing, both equities and bonds. So, we are seeing a positive correlation because rates have peaked. But we won’t be here forever and next year we expect rate cuts, so what will lead to those cuts will need to be priced into the markets.

Remi Olu-Pitan: If the rate cuts come about because growth is falling faster than inflation, then that is problematic. That will be an environment when equities will struggle, and bonds will do well. We don’t think we have enough evidence of that just yet and that is one of the reasons why rate cuts are not expected until the later part of next year. But for the time being there are good reasons to celebrate as the cost of capital has fallen.

As we go into the new year, and certainly from the second quarter, we will have to think about if the Fed needs to cut rates, why is that happening? Is it because unemployment rates are rising, is it because there are cracks in the economy? That is not a great environment for risk assets.

What impact will the interest rate peak have on real estate markets?

Tom Walker: Over the past five months I have been spending a lot of time with clients explaining what happens when interest rates peak. What’s clear when you look back on the last five peaking cycles, when you look at the performance of equities, bonds, and real estate, is that real estate outperforms.

Over the last couple of years, we have been one of the worst-performing sectors. What we look at now is a sector that’s very attractive from a valuation perspective. On our numbers, the sector is trading at close to a 20% discount.

Tom Walker: In previous cycles, when you see such a significant discount, real estate outperforms both bonds and equities on a three-year and five-year basis. It seems that the market is beginning to realise the value in the sector. We have just seen the fourth strongest month in November for our sector since the global financial crisis.

What is the impact of the divergence in fiscal policy around the world?

Keith Wade: Japan is going in very much the opposite direction, because rather than rates having peaked, they will be going up in Japan. There has been talk recently from the Bank of Japan, preparing the ground to make a move. We think this won’t be until next spring, but they want inflation to be sustained in an upward direction. So, everything that I’ve said about the UK and the US will be flipped around in Japan and they will be raising interest rates.

Keith Wade: What we have been highlighting as more of a global concern is the fiscal position of global governments. If you look at the level of debt in the OECD it has moved up significantly. It moved up quite considerably after the global financial crisis (and it never came back down again) and it moved up again after Covid. It has come down a bit, but it’s not got back to where it was before.

If we are talking about unemployment having to go up to ensure inflation comes down, then that will mean more benefit costs, less taxation being raised. Budget deficits tend to get worse, and the concern is that we are not starting from a very good place. The budget deficit in the UK is just under 5% of GDP; in the US it’s 6%. At this stage in the cycle these numbers should be 1% or 2%.

Remi Olu-Pitan: The divergence of monetary policy provides opportunities, so it’s something from a multi-asset perspective that we embrace because it helps from an asset allocation point of view. Divergence also means that the correlation across fixed income markets should subside. This year it’s all been one way. We believe that in Europe, the ECB will be one of the first to cut interest rates and might, dare I say it, actually support European equities relative to other markets.

What about China?

Keith Wade: The slowdown in the property market is a big drag on the Chinese economy. We haven’t seen a turnaround in sales, which is disappointing. There’s been lots of targeted measures to encourage people to borrow, but we know that from cycles that we’ve seen here (in the UK) and in the US that once house prices start to fall, people are unwilling to buy as they are looking to see a floor to the price falls. So, we could see future easing in China.

Keith Wade: The overarching view in China, especially from Xi Jinping, is that there’s too much debt in the Chinese property market and his view is that he wants to deleverage it. So, the trend rate of growth in China is coming down because you’ve not got that engine of growth that you used to have. It doesn’t mean that China is necessarily going to be weak; it just means that growth will be 4.5% rather than the 5.5% or 6% that we have seen in the past.

What China seems to be doing is getting its exports going again. What we’ve also noticed is that Chinese exporters are cutting their prices to generate more sales. This is good news for inflation in the US and Europe because so many goods are bought from China.

In summary:

Keith Wade: The rise in rates and yields has clearly weighed on risk assets, but as rates come down you can start to see liquidity coming back and you do start to go back to risk assets. But a lot of the debate is still going to be about how quickly rates come down and where will they level out. Don’t look at the past decade, that was an aberration. What we are looking at is maybe interest rates levelling out at about 3.5%. That’s the number people need to have in mind when they are thinking about the long term.

Remi Olu-Pitan: It’s good to stay in risk assets for now. If central banks achieve their target of a soft landing with growth stabilising, it continues to support risk assets. But maybe it’s time to fish in areas that have not done well this year. So, if rates have peaked and growth stabilises, it’s a good opportunity to think outside of the US, it’s a good opportunity to look at value, small caps; the unloved areas that should do well in this environment.

Tom Walker: While the market has been totally focussed on the macro, structural changes have continued to compound away in the background - ageing demographics, digitisation, generation rent, e-commerce. When markets refocus on real estate fundamentals, they will find a real estate market (excluding offices with all the issues surrounding working from home) in a strong position.  For a select group of landlords, we are excited by the low supply, strong demand and pricing power that will lead to earnings growth.