While the anticipation is that economic slowdowns follow rate hikes, the timing and extent of these impacts can be elusive. This global phenomenon has been evident over the past year, with even central banks like the Bank of England experiencing slower-than-usual effects.
Foreseeing an eventual slowdown remains challenging, reflecting the complexities of economic predictions. Employment dynamics in the UK, the US, and Europe have been impacted by varying demand patterns, with businesses retaining workers in the UK due to past hiring difficulties. The commercial property landscape offers a mixed outlook, marked by disparities in rental and vacancy rates across sectors and regions. And while cash gains appeal in the current climate, negative real returns and inflation must be considered.
This month, Hugh Gimber, Global Market Strategist at JP Morgan Asset Management, and James Ashley, Head of Market Strategy at Goldman Sachs Asset Management joined Square Mile’s Investment Director, Chris Fleming to explore the impact of higher interest rates on consumers, the prospects for commercial property and investing in a higher interest rate environment.
The impact of higher interest rates
Central bankers raise rates with the knowledge that when rates increase, any subsequent economic slowdown can take some time to manifest. However, the exact amount of time until any impact is felt can vary. Over the past 12 to 18 months, that variation in speed-to-impact has been seen globally, as well as in the UK. Central banks like the Bank of England have been raising rates, but the impact has been slower than usual.
In the UK, this is partly due to changes in UK consumer behaviour, such as the shift from floating to fixed rate mortgages by homeowners in the property market. Higher rates wouldn’t, therefore, affect these consumers immediately. Additionally, a higher proportion of the population already owns their house outright, so raising interest rates wouldn’t affect them as quickly either. The accumulation of savings during Covid lockdowns has also delayed the impact of higher rates as consumers have used their built up capital to cushion the blow of higher rates and inflation. Elsewhere, corporations extended their debt maturities due to the low interest rates in 2020 and 2021.
While it has taken longer for interest rate hikes to be felt, there will be an eventual slowdown, possibly around 2024. Predicting the exact timing, though, is challenging and an imperfect science.
Employment - in the UK and beyond
There are similarities and differences between the labour market in the UK and the US or Europe. The uneven distribution of demand over the past years has led to variations in labour market dynamics. In the UK, businesses may hold on to more workers due to recent memories of difficulty in hiring - softening the blow of higher rates. However, the unemployment rate is likely to rise in both the UK and the US over the next 6 to 12 months. That being said, it's unlikely to reach the levels of a typical recession.
The outlook for commercial property is differentiated. There's a notable variance in rental and vacancy rates across different sectors and regions. For instance, office vacancy rates in London's West End are much lower than in the City due to varying supply and demand dynamics. The same applies to different sectors like industrial and retail properties. Industrial spaces have a better investment case due to strong demand and limited high-quality supply. Retail spaces and offices, particularly in less desirable areas, have less market support.
Due to these differences, the granularity in analysing commercial property is crucial. It's important to evaluate each and every market segment and location on a case-by-case basis. Thorough research will reveal the dynamics in different countries and industries can vary significantly. It’s also vital to remember that, while so much focus is often on real estate, in a multi-asset portfolio the allocation of capital to it is usually relatively small even though it does have macroeconomic consequences.
Cash, equities, and bonds
Cash looks far more attractive than it has for a long time and, as a result, it's reasonable to allocate a portion of the portfolio to it. However, it’s important to remember the real returns on cash will likely be negative, given the high inflationary environment. Furthermore, the need for diversification and the potential for better risk-adjusted returns in equities or other assets still need to be considered before reallocating capital. For instance, fixed income markets, including government bonds and high-quality credit, can offer benefits within a diversified portfolio.
In terms of equity market valuations, while certain sectors or stocks might look appealing, overall equity markets may be a bit overextended - especially considering the macroeconomic uncertainties. Valuations may currently be high, in part due to market excitement over both the lower inflation and AI stories. While equities may appear expensive on aggregate, there remain opportunities within specific sectors and companies. As ever, quality businesses with strong cash flows are particularly appealing, even though caution remains necessary.
Listen to the full podcast episode below or on your favourite platform here.
This was recorded on Monday 31st July 2023. This podcast is only aimed at professional advisers and regulated firms and should not be passed on to or relied upon by any other persons. It is not intended for retail investors, who should obtain professional or specialist advice before taking, or refraining from, any action on the basis of the podcast, remembering past performance is not an indication of future performance. It is published by, and remains the copyright of, Square Mile Investment Consulting and Research Ltd. Square Mile makes no warranties or representations regarding the accuracy or completeness of the information contained herein. This podcast represents the views and forecasts of SM at the date of issue and may be subject to change without reference or notification to you. Nothing in this podcast shall be deemed to constitute a regulated activity or an invitation or inducement to engage in investment activity and it is not a recommendation to buy or sell any funds or investments that are mentioned during this podcast.