Adapting to higher interest rates

The past couple of years have seen interest rates rise steeply in response to a surge in inflation, signalling a return to economic conditions largely not seen in Europe and North America for three decades that has brought volatility to financial markets and created a new landscape for investors. A climate of higher interest rates and a permanent shift away from virtually zero inflation is likely to favour different approaches to financial assets and strategies, and investors need to ensure they are on the right side of the change*.

Interest rates have increased in response to inflation prompted by multiple factors, i.e., a combination of disruption to supply chains stemming from the Covid-19 pandemic, monetary policy that may have stayed too loose for too long, and rising commodity prices stemming from a resurgence of demand.

While inflation rates are coming down in response to monetary tightening, many economists believe it will be structurally higher in the future, certainly compared to the period stretching from the global financial crisis to 2020. Factors that have helped to keep prices low, such as cheap goods from China and its massive, inexpensive labour force, are unlikely to exert the same deflationary pull in the coming years.

Against this backdrop, interest rates are unlikely to return to the near-zero levels seen over the past decade. Low interest rates have been the defining feature of financial markets for much of the recent past, helping to determine which assets have performed well and which have languished. Investors may wish to re-examine their portfolios and consider adaptations to reflect this changed environment.

Rise in savings

The rise in savings rates has been one of the most visible shifts. For more than a decade, savers have received little or no interest on their savings, but today they can hope to obtain as much as 4%. After a period of financial market volatility, the availability of steady and seemingly reliable income, along with capital preservation (subject to the level of inflation in the future), may have some appeal. It certainly represents a significant difference from the previous environment, in which investors were almost obliged to look to stock markets to generate a return.

Even with inflation dropping, many savings accounts across the eurozone continue to pay less than the level of price rises, meaning savers are losing money in real terms.

Nevertheless, even at higher rates, cash still has its limitations. Interest rates on a savings account will fluctuate according to central bank rates, so the level of return is not always predictable. And holding a significant part of their assets in cash leaves an investor vulnerable to any future rebound in inflation. Even with inflation dropping, many savings accounts across the eurozone continue to pay less than the level of price rises, meaning savers are losing money in real terms. Cash may be the right option for short-term savings and for emergency funds, but financial markets seem to remain inescapable in order to increase wealth over time.

Investors face an even more complex dilemma regarding bond with multiple yield curve being inverted (yields being higher for short term maturities than long term maturities). The yields on benchmark 10-year German Government Bond oscillated around 2.5%for most of 2023, offering a negative return net of eurozone inflation.

Changed calculations for technology stocks

The new conditions have also changed the landscape for stock markets. The low interest rate environment benefited companies able to forecast high growth far into the future. This has been particularly noticeable in the performance of the technology sector, with the very largest US consumer technology groups far outpacing all other investment areas for much of the past decade.

Higher interest rates change the calculation for these companies. If interest rates are higher, those future cash flows may no longer be as valuable. Companies with high near-term cash flows and dividend expectations are likely to be more highly prized by investors. This has already been seen in the performance of value over growth stocks in the shorter term. The MSCI Europe Value index was up 6.1% over the 12 months to November 2023, compared with 5.4% for the wider MSCI Europe index.

In a climate of higher inflation, companies are subject to higher costs, including salaries of their workforce, industrial plant and equipment, and buildings and services. To preserve their profitability, they need the ability to pass those costs on to customers. Enhanced pricing power may come from a unique product, a dominant market share, or a market in which there are high barriers to entry. Companies selling undifferentiated products in competitive markets are more likely to struggle.

Strong balance sheets and low debt are also likely to become increasingly important if interest rates and inflation remain at higher levels than in the recent past.

The impact of companies’ debt

Strong balance sheets and low debt are also likely to become increasingly important if interest rates and inflation remain at higher levels than in the recent past. Debt has become more expensive, which is likely to weigh on corporate profitability, and it leaves companies more vulnerable to market volatility. By contrast, companies with strong balance sheets have a wider range of options – they can acquire weaker competitors, cut prices to preserve market share, or invest to strengthen their products or expand their markets.

Dividends may also become more valuable – even though this sounds counterintuitive, since dividend yields in 2023 fell below government bond yields for the first time in more than a decade. However, unlike income from bonds, dividends can grow over time. Higher dividend income helps to preserve the after-inflation value of an investment.

A new investment climate has emerged in which it has become easier to generate an income from lower-risk assets such as bonds and cash. It is likely to be a tougher environment for fast-growing companies for which most of their value lies in the future, while businesses offering reliable dividends, strong balance sheets and low debt are more likely to find favour with investors. If you haven’t done so already, it’s a good idea to reassess your investment portfolios to see how, for better or worse, it is likely to be affected by this shift. Expert help is strongly recommended here.

While inflation rates are coming down in response to monetary tightening, many economists believe it will be structurally higher in the future, certainly compared to the period stretching from the global financial crisis to 2020.

* Never forget that the delivered information should always be considered based on your personal situation and may change with the legislation.