Should we be afraid of higher interest rates?


Bond yields are raising

Government bond yields globally have been moving up significantly over the last six months, with the moves amongst the most dramatic seen for decades. Ten-year UK government bond yields have moved up 1.6% from 1% to 2.6% since the start of the year. This is the biggest move over a similar period since 1994. Moves in index-linked gilts have been of a similar magnitude with 10-year real yields moving by 2% from -3.5% to -1.5%. We might even see positive real yields if this continues. This is not just a UK phenomenon either, with yields globally also moving up significantly. US 10-year nominal rates are up 2% from 1.5% to 3.5% since the start of the year. 

Graph 1: 10-year nominal government bond rate


Source: Kempen, Bloomberg

Where bonds go, equities follow

In the short term, these rises have certainly produced a great deal of pain. As yields move up, bond prices fall and this has caused losses across government bond portfolios and credit portfolios alike. 
Not only that but, as yields have risen, equities have also fallen in value for a number of reasons. 
x Firstly, equities are priced based on the value of future dividends in today’s money, and as bond yields rise, the value of those future dividends in today’s money falls. With the rise (and rise) of stocks that are almost entirely anchored on stratospheric dividends in the future (and little today), sharp corrections are not surprising. 
x Secondly, if investors can earn acceptable returns on risk-free (or at least lower risk) assets, they no longer have to take the risk of owning equities. 
And finally, investors are worried that rising interests rates will cause a recession and this will lower future dividends and therefore returns.

What goes up must come down

The combination of lower bond prices and lower equities has led to a very difficult investment landscape, where it has been almost impossible to escape losses. This can be extremely disconcerting especially for those who are used to the outsized returns seen since 2009. 

However, I would argue that what is happening here, at least in equity markets, is not that unusual and we can afford to be a little less panicked. 
We have been spoilt since 2009, with large and consistent returns for equities which were barely interrupted by the sudden falls and remarkable recovery seen during the pandemic. But this is not normal: between 1987 and 2009 there were four occasions when the MSCI World Index fell by 20% or more, roughly once every six years. Going from 2009 to 2022 with only one of these events (ignoring the 2020 falls) is more unusual than the 20% correction we have had since the start of the year. 
Equity markets will inevitably recover, even if it takes a number of years. As always, time in the market is significantly more important than timing the market. What we are seeing now, albeit in turbo mode, is akin to the business cycles we saw pre-2008, with demand increasing relative to supply, inflationary pressures increasing and Central Banks increasing interest rates to bring inflation down.

On this occasion, it looks like Central Banks are behind the curve and may have to actively engineer a recession to bring inflation down. But there has not been a recession in the US or UK since 2009, which is not in itself normal (and indeed may not even be healthy). Part of what keeps economies expanding is the creative destruction of economics, bad firms go bust, good firms grow. Part of this process is helped by a recession; rather like a forest fire, it clears out the dead wood and allows labour and capital to move from less productive forms to more productive ones. In the short run it can be painful, but in the long run it makes everyone better off. We have not had anything like this for over a decade and some commentators suggest complacency may be harming productivity.

The impact on hedging

In many ways, persistently high inflation is worse than a recession - it is particularly hard for those on fixed incomes, it makes spending and investment decisions much more difficult for business which in turn hurts growth, it erodes the value of savings and ultimately leaves individuals and economies worse off.

Pension schemes are tricky beasts in this context. Ultimately, higher interest rates will probably reduce long-term deficits, even for schemes that have high hedge ratios. A reduction in the size of the assets and liabilities will also mean a reduced size of the total pension fund.

x For schemes that receive deficit repair contributions from the sponsor, these will now cover a larger percentage of the GBP amount of any deficit, as well as reducing the absolute size of the pension fund relative to their sponsoring employer. 
x Those schemes with stronger covenants may even be bucking the trend on ever higher hedging on a tactical basis, as well as considering de-risking opportunities and even taking advantage of the fact that buy-out pricing, and other pension scheme risk transfer solutions including consolidation, have moved in their favour by several years.
This does feel like a forest fire today; but the green shoots will eventually start to appear.

About the author:

Robert Scammell is a senior portfolio manager responsible for developing Kempen’s LDI proposition for UK clients, sitting on both our UK Asset Allocation Committee and UK LDI Committee.


 

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