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By Emma Wall| 3-28-2018 12:00 PM

What do Rate Rises Mean for Investors?

Much has been made of the impact of rising interest rates on bond investors - but how does a hike impact equity markets?

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Emma Wall: Hello, and welcome to the Morningstar series, "Market Reaction." I'm Emma Wall and I'm joined today by Dwyfor Evans from State Street to talk about rising interest rates and their impact on global equity markets.

Hello, Dwyfor.

Dwyfor Evans: Hello, there.

Wall: So, last week we had the Fed raising interest rates and we had very key indications from the Bank of England that May would see a rate rise in the U.K. What does a rising interest rate environment mean for global markets?

Evans: Well, it's often regarded as being a tightening of policy and obviously, that's looked upon as being trying to take some of the steam out of risk markets. Truth of the matter is that interest rates are being raised because global growth is relatively strong. So, risk markets look to be quite well supported here still with rising interest because they are rising from a very low level.

What it does do, I think, is it makes it a little bit more interesting in terms of the interplay between equities and bonds. And so, you will see possibly a rotation out of one asset class into the other. But generally, for risk markets, at this particular level, it doesn't really matter that interest rates are coming from such a low, sort of, base. But it's a tightening of policy. So, clearly, it's showing us that global markets generally are quite strong at this point.

Wall: There is an argument, of course, that this should have happened a long time ago and that the global growth was there to support rate rises last year, even the year before. What does it mean that we've left it so late, or central banks have left it so late, does that have a particular impact on global markets?

Evans: Not really, except for the fact that possibly they have allowed a little bit too much froth in terms of risk markets. So, back end of 2017, we were talking about how the Fed could hike rates and would have a negligible impact on markets. And the Fed decided to be very, very cautious in the way that they were actually hiking rates. What that has basically meant is that of course risk markets then had another leg up at the end of last year, the early part of this year before we started to have the volatility.

So, maybe central banks could have acted a little bit earlier to – and I guess, if there is a criticism of central banks in hindsight when we look back in years to come, maybe they have allowed the risk cycle and the risk trade to have extended just a little bit too far. The truth is, of course, we really haven't had an inflation.

So, the central banks are very much within their rights to turn around and say, well, we didn't really hike aggressively because we just couldn't see any inflation anyway and the last thing we want to do obviously with no inflation is to actually tighten too much and cause some sort of downturn or some sort of recession. So, they had a balance here between not wanting to cause a recession and still wanting to ensure that they are being sufficiently cautious given the inflation backdrop. So, all in all, I think they will be looked upon as having done a decent job, but they did allow a little bit too much froth probably in terms of some of their signals over the last six months.

Wall: Now, inflation is a key point. You said at the beginning of the year that inflation could be the thing that derailed this considerable rally we've seen across both developed and emerging markets. Is that a concern in 2018 that inflation will show its head and indeed will be derailed?

Evans: Actually, some of the proprietary material that we look at when we look at online prices as a leading indicator official prices, it was telling us exactly that in January, but it's really gone into reverse in February and March.

So, actually, when we look at the inflation today, really on a quarterly basis, we are not seeing anything other than a normal sort of pickup in inflation, nothing that suggests overshooting targets, nothing that suggests that the bond market is set for some calamitous sort of downturn. It simply looks now as if we are moving towards target gradually. In that respect, going back to my earlier point, I think, central banks have timed this just about right; maybe a little bit late but just about right. But there is nothing on the horizon to actually suggests that inflation is blowing out.

Now, in that respect, of course, when you look at something like the Fed and you look at the Bank of England, I would imagine that caution is still going to be the watchword for the next six months or nine months or so until they actually see what is a far deeper and more entrenched level of inflation. It's not there yet.

Wall: And inflation is not there yet. And these rate rises are too small in increment to have an impact on equity markets. What are the threats to equity markets? Or do you expect this rally to continue for some time, at least the medium term?

Evans: You have to look through the noise and there is a lot of noise out there now on trade and protectionism. The trouble with protectionism is the if it does have a negative impact on growth, that will hit on earnings growth. And really, what we have seen the runup that we mentioned earlier in terms of equity prices, have really been driven by coordinated global growth, seemingly very little threat in terms of political or macro environment to that growth environment.

And now, of course, if we are shifting toward a far more protectionist global situation, trade takes a back seat or at least trade takes a hit in any case, and of course, that then partly erodes global growth at the same time.

So, then there has to be a repricing in terms of risk markets, because risk markets have priced in this particular sort of growth trend. If we are reassessing that then we are going to reassess that to the downside, given that it basically manes that we need to I guess reprice earnings and reprice corporate behaviour. So, that's probably one of the risks. I think that's at moment more noise.

One other impact, of course, on protectionism is inflation, because it will imply higher prices. So, we are back to the story of higher inflation again. I think that will be seen by central banks as also largely transitory.

So, I don't think at this particular point I would get too concerned about some of the trade talks and protectionism talks that are going on right now. It's more noise, but it is having an impact clearly on how people are seeing global growth going forward. The longer this goes on, I think, the more negative people will get on the prospects for global growth for this year and beyond and they will have to start readjusting their portfolios accordingly. That's probably the big risk out there right now.

Maybe another risk is that we've simply seen a recovery that's gone on for a very long time. It's a multiyear recovery now in the U.S. The U.S. tends to sort of lead most of the other sort of western world. You see Europe and the U.K.; to a lesser extent in the U.K. given Brexit issues. But Europe in particular has sort of joined the higher sort of growth trend I guess with a lag to the U.S.

If we are now seeing, I guess, a tightening of the labour market such that it's very difficult to squeeze out more productivities, more difficult to squeeze out more employment gains without inflation and that changes the dynamics in the U.S. as well actually. So, that potentially means that we could see some sort of a levelling off in terms of the U.S. growth rate. The counter to that, of course, is the tax cuts that we saw back end of last year.

So, there are lots of things going on here. I think the risks of this particular point to global growth are actually quite low. They seem to be largely driven by the trade talks that are ongoing, also by some of the geopolitics as well, but I would look at this more as noise right now rather than anything that has a firm sort of long-term end game.

Wall: Dwyfor, thank you very much.

Evans: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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