Lower for longer

The potential rewards are higher borrowing and spending as consumers and businesses are spurred on to take advantage of the low cost of credit. The risk is the creation of a credit bubble, damaging savers and threatening the viability of banks and insurers to meet their obligations.

UK economic growth seemed relatively assured during the first half of this year. Second-quarter gross domestic product (GDP) rose by 0.6 per cent, twice the rate of the US and eurozone economies. What’s more, in June the annual growth rate in the stock of consumer credit reached 10.3 per cent, the highest since December 2005. Post-referendum, business and consumer surveys have generally been more pessimistic.

However, not all the blame for rock-bottom interest rates can be laid on post-referendum gloom. Real rates – interest rates minus inflationary impact – have been in decline since the late 1990s. It is generally agreed there is a strong correlation between expected economic growth and real yields. People with heightened anxieties over job security and wage growth will be less willing to borrow, reducing demand for credit. The finger has been pointed at an excess of global saving, a slowdown in world trade and weaker capital spending by companies, which in turn has reduced aggregate demand.

While global economies were already struggling to recover from the 2008 financial crisis, post-referendum uncertainty – with some economists forecasting recession – has heaped pressure on yields. Yet the fact that long-dated yields have been most affected tells us investors reckon interest rates are going to stay lower for longer.

The central bank plans to boost its reserves by £60bn during the next six months, aiming to purchase equally across three gilt maturity segments. However, things got off to a bumpy start for the BoE. It was only able to buy back £1.12bn in 15-year government debt – less than the £1.17bn it wanted. Fortunately, its second round of bond buying was more successful. The real question is whether Mr Carney’s stimulus plans will be enough to protect economic growth.

Still banking on income?

A reduction in interest rates is designed to stimulate borrowing from banks, by businesses and consumers that can take advantage of cheaper rates. It also reduces the incentive to keep cash locked away in bank accounts, earning a measly return. In theory, this should work well for encouraging mortgage lending.

The trouble is that when base rates are kept low or cut even further, the normally higher interest rate banks can charge on long-term loans comes down in relation to the rate paid on their short-term borrowings. Banks’ deposit costs will also fall and some banks, including Santander, have already cut the rates they offer customers on their deposits. However, retail banks must tread a fine line in order to maintain customer numbers. The extent to which the UK’s banks are impacted will vary according to the different levers they are able to pull to mitigate lower interest rates, as well as the make-up of their individual loan books. The BoE has come up with one way to help, introducing the Term Funding Scheme. This allows banks to borrow up to £100bn of newly created funds at a rate near the ultra-cheap base rate. Each can borrow up to 5 per cent of their existing loan books, as well as extra funds equal to the increase in net lending in the following months.

Yet the size and duration of the banks’ structural hedge also presents problems when interest rates are cut. Banks put in place structural hedging to reduce the impact of short-term fluctuations in interest rates on fixed-rate assets or liabilities they hold on the balance sheet; for example non-interest-bearing current accounts. The idea is that by buying interest rate swaps banks receive a more stable, medium-term rate of return.

However, a cut in interest rates results in lower hedge income. As rolling hedges reach the end of their duration they are reinvested at lower interest rates. Therefore in a falling rate environment it is beneficial for a bank to have in place a high duration on its hedging portfolio, so it re-prices to the new lower rate environment more slowly and, in turn, squeezes net interest margins.

Royal Bank of Scotland (RBS) has a higher proportion of non-interest-bearing current accounts than peers Lloyds Banking (LLOY) and Barclays (BARC), meaning it is more vulnerable to pressure from lower interest rates. What’s more, around 80 per cent of its UK corporate loans are variable rate. Having said this, Lloyds revealed a higher than expected hedge of £120bn alongside its first-half results in July. However, management said it had stopped reinvesting maturing hedges due to the low yields on offer.

Still, Lloyds has several factors working in its favour. The bank has a lower proportion of non-interest-bearing accounts and is more able to offset reduced hedge income with lower deposit costs. There is also the issue of competition. Following its 2008 acquisition of Halifax/Bank of Scotland, Lloyds has a competitive advantage, with the largest share of the UK retail market, at around 30 per cent. Meanwhile, more customers switching to lower-margin fixed-rate mortgage products has already damaged RBS’s net interest margin.

Bank interest rate sensitivity in changing rate environment

The effects of low rates are already being felt by the mainstream banks, with RBS, HSBC (HSBA) and Standard Chartered (STAN) each pushing back the timetable for achieving their target return on equity. A stumbling block for returns could also hinder dividend payments and make it even harder for banks to regain their status as income stocks. For RBS, this could impede its return to making dividend payments.

European banks are in an even worse state. Undercapitalisation and bad debts are being compounded by the pressure of low interest rates. The European Central Bank (ECB) has held rates below zero since March. In Italy many smaller banks, as well as number three lender Monte dei Paschi, are struggling to stay afloat. A plethora of bad loans may be the heart of the problem, but margins are also being squeezed by low rates. In August the ECB hinted it may take further action if economic conditions in the eurozone do not improve.

Progress made by UK banks since the 2008-09 financial crisis has been modest. The fact that interest rates have been kept at such low rates for a sustained period of time has held back banks’ ability to kick-start their earnings. And when the level of provisions against bad debt, mis-selling of payment protection insurance and litigation is considered, as well as restructuring charges, it is easy to see why a return to profitability has been an uphill struggle for the majority of UK-listed banks. Shares in banks have re-rated significantly following the referendum, with the threat posed by a potential downturn and lower interest rates to some extent now priced in. Nevertheless, banks make a high-risk investment.

Insurers must work harder

Life insurers were quick to rebuff concerns that the reduction in interest rates would hurt business when unveiling their first-half results in August. Aviva (AV.) chief executive Mark Wilson said at the time that the group was “performing pretty well with the rain clouds looming”, pointing out the group’s hedging strategy that matches its assets and liabilities.

Falling interest rates push up the value of an insurer’s liabilities, which they seek to match by investing in long-term assets such as gilts or corporate bonds. While insurers including Standard Life (SL.) and Legal & General (LGEN) have started cutting their annuity rates, historic annuities sold when interest rates were higher – and therefore promising a higher rate of return to retirees – still present a problem.

For Legal & General, which is the most geared towards bulk annuity work, the fear is that reduced rates could push up pension schemes’ liabilities and the cost of completing a deal with an insurer, resulting in a slowdown in business. Elsewhere, L&G is feeling the pain of low rates. Its insurance business reported a two-thirds decline in pre-tax profit, as a reduction in UK gilt yields lowered the discount rate used to calculate the reserves for its UK protection liabilities.

Yet the numbers have held up pretty well so far for the UK’s life insurers, with all bar L&G experiencing a rally in their shares following the release of their first-half results earlier in the summer. For Standard Life, its asset management continued to buoy its performance thanks to an increase in more stable, long-dated work for institutional investors. Admittedly, it could face some headwinds from fixed-income investment, adding to pressure from equity market volatility. Crucially, the capital position of all the life insurers has remained sound. Despite reductions in Solvency II positions, coverage ratios remained comfortably within target – with Standard Life the lowest at 154 per cent – and shareholders received healthy increases in dividend payments.

However, some general insurers have not been so fortunate. Admiral (ADM) chief executive David Stevens warned of low interest rates dampening the value of the group’s own funds – held to pay out future claims – when it announced its first-half results. The downturn in the yield curve amounted to a 20 percentage point decline in the insurer’s Solvency II ratio to 180 per cent.

Lloyd’s insurer Novae (NVA) has already altered the way it invests the premiums it earns. Last year management decided to invest a greater proportion of its portfolio in growth assets and lengthen the duration of its investments. While the insurer suffered some reductions in the value of its equities during the first half of the year, its total investment return net of management fees increased to 2.2 per cent from 0.3 per cent in the previous year. While management said its risk profile remained the same following the changes, for others investing in more growth assets could result in a much riskier strategy.

Housebuilders could reap rewards

With UK interest rates at record lows, it’s not the best time for investors looking for a decent return on cash investments, but it’s good news for housebuilders. Mortgages are now more affordable than ever before and, coupled with a raft of government-sponsored incentives, most notably the Help to Buy scheme and interest free loans, demand for newly built homes is holding up well. Unlike the years leading up to the financial crash, housebuilders are much better capitalised and have much lower gearing. So, while lower bank interest charges are always welcome, the beneficial effects are that much less than they were in previous times. The primary driver for continued growth is the health of the economy, which in turn affects unemployment, or more specifically the fear of unemployment among potential buyers, and the level of interest rates. Both are currently huge plus points for the builders.

Real estate companies need access to bank loans just as much as any other company, although banks have been a lot more selective about what the money is spent on. This is a natural consequence of the financial crash when valuations collapsed and banks were faced with the option of calling in loans as covenants were breached or giving companies more rope in the hope that conditions would improve. There are still restrictions, however, and loans for speculative developments are much harder to come by. So real estate companies looking to build or refurbish are more inclined to seek finance for schemes that are largely pre-let.

Perhaps the best conditions are enjoyed by those companies with a large exposure to mainland Europe, where the European Central Bank is encouraging banks to lend. Loans can be secured on a five-year fixed-rate basis for as little as 0.8 per cent. That’s not quite the case in the UK, where the cost of capital is more likely to be in the region of 3-4 per cent. This is quite acceptable when initial rental yields are higher than this, but events could change if interest rates were to rise significantly, although the chances of this happening in the near to medium term appear to be pretty remote. JC

A gold rush for commodities?

In theory, low interest rates should be good for commodity prices. To understand why, consider the effects on the life cycle of a commodity: suppliers have lower capital costs, and thus fewer incentives to extract today; lower storage costs mean intermediaries are less desperate to sell inventory; and holders of capital have fewer incentives to save, and a greater appetite to invest in resource-intensive projects. Supply is dampened and easily restricted, and demand is higher.

And as almost all commodities are set in US dollars, a low Federal Reserve rate should provide a further boost. That’s because low US interest rates should depress the value of the dollar, and give holders of other currencies more weight to buy dollar-priced assets, from oil and copper to soybeans.

In theory, then, the equities that are most reliant on firm commodity prices – the oil and mineral producers and explorers – should be doing very well at the minute. To a limited extent, this has been true. Prevarication and delay at the Federal Reserve over a further interest rate hike has played a role in the bounce in commodity prices so far this year, although somewhat counter-intuitively the US dollar remains stubbornly high. The biggest reason for this is its status as a safe-haven asset at times of global uncertainty.

However, the relationship between interest rates and commodities should not be overplayed. If there is one big lesson from the slump in metal prices in the past few years, it is that the balance between global (read Chinese) demand and global supply (or oversupply) dictates price. That’s been punishing for iron ore giants such as Rio Tinto (RIO) and Vale (US:VALE). Similarly, the lowering of the oil price has ultimately been down to a doubling in US domestic production in recent years, coupled with other large producers’ refusal to curtail supply. That’s caused damage to all producers, including oil majors such as BP (BP.) and Royal Dutch Shell (RDSB).

Nonetheless, commodities should benefit if low interest rates persist. This is particularly true of assets such as gold, silver and diamonds, which, according to a study by Credit Suisse and economists at Cambridge University and London Business School, were found to be the most sensitive to real rate movements over the last century. In fact, silver prices grew 8.9 percentage points more per year during falling rate environments.

Given the strong rise in gold and silver prices this year, some think this historic pattern for precious metals may be coming unstuck. Normally, a relatively strong dollar and the prospect of rising rates have long been thought of as bad signs for gold prices, as investors are happy to safely park their money in interest-paying accounts. However, the growth in negative interest rate policies (NIRP) since the financial crisis has left myriad investors hunting for low-cost safe havens, which in turn has left precious metal miners such as Fresnillo (FRES) and Hochschild Mining (HOCH) in the money. AN

Consumer gains neutralised

Lower interest rates work in favour of consumer-facing industries, particularly those sensitive to consumers’ disposable income levels. Research from Credit Suisse shows that in low interest rate environments returns on retail investments tend to fare well. The reason for this is relatively simple. If the Bank of England cuts interest rates or keeps them flat banks aren’t able to offer customers high-interest savings accounts. The idea, therefore, to spend instead of save, starts to look more attractive. It also means customers head out to spend on things that generally incur interest – mortgages being the obvious example – while they’re going cheap.

The idea of a ‘consumer-facing’ stock is multi-faceted as most of the sectors discussed in this magazine interact with customers, albeit some more directly than others. For the sake of this section, we’re talking about retailers – both general and food – and leisure companies such as cinemas, restaurant chains and theme parks. Of course, a crucial stimulus for this sector is inflation, but preferably wages rather than prices. The two are usually correlated and therefore any benefit can be cancelled out. But in a low interest rate environment, if wages are on the rise, the odds still look good for the sector.

This might not feel like a relative argument in the face of a possible recession but, actually, the introduction of the new living wage (NLW) in the UK is still a developing trend. If you’re working, and aged 25 or over and not in the first year of an apprenticeship, you are legally entitled to at least £7.20 an hour. That’s an extra 50p per hour than the minimum wage and the government has said it’s committed to increasing this basic level every year. By 2020, it’s thought the NLW will be close to £9 an hour.

All in all, customers – even those at the bottom of the spending food chain – will have more cash to splash. But it also means that companies have to pay their staff more, and may have to cover the cost through price increases rather than allowing margins to suffer. This leads to overall price inflation – hence the aforementioned neutralising effect. Although customers have more to spend thanks to their higher pay packet, they’re asked for more at the shop till.

From a retail and consumer perspective our top picks include luxury retailer Burberry (BRBY) and high-street fashion chains JD Sports (JD.) and Ted Baker (TED). These companies, however, tend to trade at high multiples and investors will be forced to shell out to hold the shares. In our view, they’re all worth the money thanks to their reliable brands and concentration on growth rates. HR