Investing in the face of rising rates

Last week, the Federal Reserve raised interest rates by 25 basis points to 2–2.25%. As the move was widely expected, it had little impact on most financial markets. But one immediate consequence has been higher interest rates on USD cash and cash equivalents.

These rising cash rates mean that, on a risk-adjusted basis, holding cash is looking more attractive relative to investing in other assets like bonds, equities, and real estate, and is prompting some investors to question their investment positioning.

Equities

We keep a tactical overweight position in equities.

• The economic and corporate earnings picture remains solid. We expect global economic growth of 4% this year and 3.7% next year. Global earnings are on track to expand by about 15% in 2018 and around 10% in 2019. And there are potential upside scenarios to growth. Developed market consumers are in good shape: savings rates have been revised up, and strong labor markets could contribute to higher consumer spending. All this together suggests that although the long-term return potential of equities is looking more limited relative to cash, over our six-month investment horizon investors can reasonably expect equity returns to deliver a premium to cash.
• We also seek relative value opportunities, like our overweight position in US large-cap value versus growth.

Fixed income

In fixed income, higher cash rates and a flattening yield curve mean investors need to seek either healthy spreads, or portfolio diversification opportunities.

• We recently added to our overweight in emerging market (EM) US dollar-denominated sovereign bonds. Despite the current uncertainty in EM assets, the EMBI Global Diversified Index is well-diversified across issuers and offers a 6.5% yield that looks increasingly attractive versus government bonds.
• With the yield curve having flattened, longer-term government bonds offer less of a return premium over cash, but they have additional appealing portfolio diversification properties. We would expect government bonds, and 10-year US Treasuries in particular, to perform well in risk scenarios such as a China economic slowdown and political/economic turmoil in emerging markets. We recommend a tactical overweight to 10-year Treasuries, with a 10-year Treasury yield forecast of 3% over the next 12 months.

Real Estate

In real estate, historically investors have had to be alert to significantly rising interest rates, which have historically been a contributing factor to corrections.

• Following the Fed’s hike, for example, the Hong Kong Monetary Authority raised rates by 25bps, the first increase since March 2006. Hong Kong has the world’s most overvalued property market and faces the greatest risk of a housing bubble, according to the UBS Global Real Estate Bubble Index published last week. Higher rates can further reduce housing affordability for borrowers, unless prices fall.
• That said, although we believe investors should remain selective in housing markets in bubble risk territory, we do not see excesses in lending and construction. Outstanding mortgage volumes are growing significantly slower as compared to the run-up to the global financial crisis. In addition, mortgage underwriting standards are considerably more conservative following the passage of Dodd-Frank. In our view, these factors should help limit the economic damage of any possible price correction.

Bottom line

Last week, financial markets took the latest Federal Reserve rate hike in their stride. But rising cash rates mean that on a risk-adjusted basis, cash is looking more attractive relative to investing in other financial assets, leading some to question their investment positioning. We remain overweight global equities, see diversification and spread benefits in fixed income and, while cautious on some overvalued real estate markets, do not see widespread lending excesses.

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