Waverton's thoughts on interest rates and inflation

Ask your family and friends where they think interest rates are heading and most will say higher.  Given that UK Base Rates are at a 300 year low, this seems a highly reasonable expectation.  The UK economy has only just surpassed the level of economic activity that was achieved in the peak ahead of the Global Financial Crisis in 2008 (as measured Gross Domestic Product).  Six years of stagnation has left us with an absence of that feel-good factor but the Bank of England has been tasked with reviving it.  Its main tool has been the level of interest rates but Quantitative Easing and various lending initiatives have also been employed.

The problem with the extended contraction is that we have all got used to these very low rates.  If you were to survey professional investors where they see rates heading they will probably come up with a figure of around 3% in 3 or 4 years’ time.  That is what is discounted in the forward interest rate futures market.  When Charlie Bean, Deputy Governor of the Bank of England, recently mentioned that rates might go back to 5%, it made the front page.  But 5% is well below the average over the last 50 years.

More often than not, consensus expectations are wrong.  Not always but normally.  So where is the error in this estimate?  Is it sensible that, with the strongest growth in the G7, with a very dovish Governor of the Bank of England, with one of the poorest inflation records in the Developed World and where unemployment has dropped from 7.8% to 6.5% in just 18 months, the UK should not see some inflation pressure in the near future?   The Bank of England recently reported that there are sporadic signs of skills shortages and wage increases in the economy. Are these the first signs of a pick-up in inflation?

Clear signs of inflationary pressure are scarce, but standing back from the noise of daily market chatter and monthly published economic data, it seems that inflation risks must be on the upside and therefore interest rate rises are likely.  The investment consequences from this view are complex and uncertain but it seems sensible to reduce interest rate sensitivity.  Given the complacent stance towards these risks, we think there is a danger of negative returns from Gilts and that highly rated defensive equities could underperform.  Moderate inflation and higher interest rates are not necessarily negative for equity markets, in fact the experience of the last decade suggests the opposite, but an inflexion point where the market has to adjust interest rate expectations could cause volatility to rise from its very low level and lead to significant rotation within the equity market.

Jeff Keen