Interest rates are being discussed passionately across the land as households and businesses are faced with sharp increases in the cost of debt. After more than a decade of near-zero rates, highly leveraged economies that geared up during the easy times are now faced with a reckoning. Investment bank Berenberg thinks that the debt surge “presents a dormant system risk to the global economy and to global financial markets”, a risk exacerbated by higher rates.
A central reason for the panic in the air is that a generation had become used to historically unusual rock-bottom rates. Rates have been on a general downward trend since the 1980s, with the ultra-low and even negative interest rates seen in recent years not having much precedence. Some financial historians think the low-rate experiment is at the heart of our economic malaise. Edward Chancellor argues in The Price of Time: the Real Story of Interest that ultra-low interest rates have contributed “to many of our current woes, whether the collapse of productivity growth, unaffordable housing, rising inequality, the loss of market competition or financial fragility”.
Be that as it may, the pivot into a higher-for-longer rate cycle is now here. Interest rates in the US (5.5 per cent) and UK (5.25 per cent) are at their highest levels in 22 and 15 years respectively.
This new environment has big implications for equities. Quite apart from boosting bond yields after their long slumber (see chart), the sensitivity of different share sectors to rate movements can be seen in company earnings figures on a daily basis.
Long-term data supports common assumptions about cyclical equity sectors. Analysis of returns data between 1926 and 2015 made by economists Elroy Dimson, Paul Marsh, and Mike Staunton found that defensive sectors such as utilities and telecommunications do best after rate rises while retailers and consumer durables do worse. In reality, of course, many companies in each of those sectors have bucked this trend since rates started moving higher: company fundamentals still matter, after all.
As one would expect, there are very different views across the investment community about equity sector allocation in a higher-rate environment. And it is important to note that the path of interest rates is only one factor to consider when it comes to sector and share selection.
Deutsche Bank head of European equity and cross-asset strategy, Maximilian Uleer, told Investors’ Chronicle that investors shouldn't change their sector allocations just because of higher interest rates, but should nonetheless focus on credit duration and debt-to-equity and interest coverage ratios. It is about "finding sectors which have a nice balance between earnings growth and interest costs", he said.
To illustrate this, let’s dive in and look at the impact of rates across five quite different sectors.
Mortgage madness
The obvious place to start is the housing market, given both its high sensitivity to interest rates and its place as the UK’s national financial obsession. As interest rates have risen, those taking out mortgages have been able to borrow significantly less than in the recent past and those remortgaging are in many cases being faced with huge surges in monthly payments.
There has been much debate about the potential for a collapse in property prices, which fell by the largest annual amount in 14 years in July, yet on the whole have proven relatively resilient so far, according to Nationwide. Capital Economics senior property economist Andrew Wishart expects a 30 per cent year-on-year drop on mortgage approvals across 2023 and a 12 per cent fall in house prices between the August 2022 peak and the end of 2024.
Taylor Wimpey’s (TW.) half-year results provided some insight into how borrowers are dealing with higher rates. The housebuilder said that 27 per cent of its first-time buyers are now taking mortgage terms of over 36 years, up from 7 per cent in 2021, and the proportion of 'second-time buyers' taking out mortgages of over 30 years rose from 28 per cent to 42 per cent across the same period. Despite headwinds, the company's housebuilding forecast was at the high end of its guidance range. We like the company for its discount to net assets and its dividend yield, along with its significant landbank and cash reserves. Operationally, it is faring relatively well in the face of higher rates.
The sensitivity of housebuilders to rates (real and expected) has been apparent at the points when economic data is released. When the UK consumer price index inflation reading came in at a lower-than-expected 7.9 per cent last month, companies such as Barratt Developments (BDEV), Redrow (RDW) and Persimmon (PSN) made gains.
But there are relative winners and losers here, as everywhere. Analysts at JPMorgan downgraded their recommendation on Persimmon in July to neutral, pointing to “incremental downside risks to estimates” across the sector. The investment bank is most keen on Berkeley (BKG) amongst the housing shares, arguing that its premium range and relatively high proportion of international customers make it well-placed to ride out affordability risks.
While we take the wealthier buyers point, we rate Berkeley a sell because of its chunky premium to net asset value and forecast of a big sales drop. At the same time, many of those housebuilders who sell to the less well-off (those whose buying power is most impacted by rising rates) aren't looking good, either – one reason we aren't keen on Persimmon.
Among the real estate investment trusts (Reits), those who own offices (particularly City or out-of-town sites) are faring badly as higher rates bite. We are bearish on Helical (HLCL), the share price of which is down by over 30 per cent year-to-date.
Keep up to date with all the latest news from the property sector here
Banking interest
Unlike housebuilders, banks are often seen as a beneficiary of higher rates. The sector has gained as net interest lines (the spread between what they earn on their assets and pay out on their liabilities) bulge on the back of higher rates. But it is not all good news, as consumers chasing better deals take deposits elsewhere and bad loan charges head in the wrong direction.
This unclear picture was demonstrated well by second-quarter results. Higher rates drove income at Barclays’ (BARC) UK consumer division upwards by 18 per cent, but investors are quick to factor in such gains and quick to be disappointed when more don't materialise. The bank's net interest margin for 2023 is now expected to be less than 3.2 per cent, a forecast that contributed to a more than 5 per cent share price fall on results day. Lloyds Banking Group’s (LLOY) profits surged by almost a quarter in the first half against last year, but the lender’s bad loans charge increased by £176mn quarter on quarter. NatWest (NWG) cut its net interest margin forecast from 3.20 to 3.15 per cent, but its return on tangible equity came in above target, one reason we have reaffirmed our buy call.
RBC Capital Markets analysts mused back in June on whether rates are now “moving out of their sweet spot” for UK banks. Deposit, and other, pressures have increased since then. But the bank’s argument that “structural hedge income tailwinds are significant and should underpin sustainable, low-to mid-teens return on tangible equity” still looks accurate.
Over at Berenberg, analysts think that UK banks look attractive against European counterparts, commenting domestic banks’ “21.5 per cent implied cost of equity is two times the long-run average and 4 percentage points above that of Italian banks”.
Across the Atlantic, higher rates are also driving earnings significantly upwards, at least for now. Net interest income rose by 44 per cent at JPMorgan Chase (US:JPM), by 29 per cent at Wells Fargo (US:WFC), by 16 per cent at Citigroup (US:C), and by 14 per cent at Bank of America (US:BAC) in the second quarter. On the downside, there was a consumer deposit slowdown at JPMorgan and a 21 per cent collapse in non-interest-bearing deposits at State Street (US:STT). This is a warning that investors aren't going to accept any old yield when rates are on the up.
And then there is the retrenchment in dealmaking, as higher rates have been bad news for mergers and acquisitions (M&A). Private equity markets are facing serious questions about debt and valuations, issues that have meant a very low level of IPOs and a hit to advisory fees on Wall Street. The big US players booked over $1bn (£790mn) of layoff costs in the first half of the year after a hiring spree during the pandemic. The M&A market has a long way to go to adjust to a higher-for-longer rate environment.
The utility of defence
Utilities shares are often viewed as ‘bond proxies’: companies that provide steady, regulator-backed revenue streams for investors with better yields than on debt. Returns linked to inflation are indeed a key sector attraction, and the sector looks cheap compared to the MSCI AC World index, but high leverage means that certain shares look relatively unattractive in a higher-rate context.
The London-listed water companies – Severn Trent (SVT), Pennon Group (PNN) and United Utilities (UU) – have come under increasing pressure from the public, politicians and environmental groups. Capital investment levels have been compared unfavourably to dividend payouts across the sector, as stories about raw sewage being pumped into seas and rivers fill the headlines. And while gearing levels are just about in line with the regulator's metric, a lot of debt is inflation-linked.
There is also a lot of debt on the balance sheet at National Grid (NG.), but a saving grace is that around 80 per cent of this is long-term and fixed. The 11 per cent that is index-linked is being hit by higher rates, although that looks manageable. For JPMorgan, the company “offers the most attractive investment case for those investors looking to position more defensively within the sector in coming months”. We are also bullish – we moved to a buy on the company in July based on its sustainable energy potential in a supportive government policy environment. Another utility we are bullish on is Centrica (CNA), which we think has a position of unrivalled strength in the market.
Candriam head of multi-asset quantitative research Olivier Clapt, backing up Dimson et al, has found that the historical data supports taking a serious look at utilities in a period of rising rates. In his analysis of seven periods since the 1960s when the Federal Reserve increased rates by a minimum of 230 basis points over one-to-three-year periods, he argued that overweighting utilities (and energy) shares maximised risk-adjusted real returns for a volatility equal to a 50/50 US equity and bond portfolio.
UBS UK chief investment officer Caroline Simmons told Investors’ Chronicle that "we like utilities and consumer staples [in a context of higher rates] because they are defensive sectors and even though rates are going up the growth backdrop is slowing, meaning rates should come down again within 12 months".
"Utilities don't tend to do well as rates rise due to the higher cost of debt, but as rates have been so low for so long a lot of companies have fixed their debt, and their valuations are attractive,” she added.
Durable telcos
Leverage is also a key risk factor with the telecommunications (telcos) sector, which on the face of it makes companies in this area exposed to higher rates. According to Fitch, telcos come in third behind the healthcare and pharma and technology sectors when it comes to the value of outstanding loans. But with this sector also enjoying long credit duration (of an average of 5.5 years, just behind healthcare and travel and leisure, according to Deutsche Bank), here too companies have a good amount of time until they have to refinance debt, reducing the dangers of rate increases.
Deutsche Bank upgraded its position on telcos to overweight the day after a sector sell-off in June, arguing that "while other defensive sectors screen expensive and could see pressure in an environment of rising real rates, telcos screen cheap and tend to do better in an environment of rising real rates".
But that doesn't mean that higher rates aren't having an impact on the sector. Costs are being cut, as seen in the announced plans to shed tens of thousands of workers by BT (BT.A) and Vodafone (VOD), and capex plans are becoming more expensive. Vodafone's return on invested capital would be helped by the merger with mobile operator Three, announced in June, were it to be approved by competition regulators. When it comes to consumers looking to save on costs in a more expensive environment, Telecom Plus (TEP) has benefited. The company reported in its latest annual results that customer numbers increased by more than a fifth, yet its valuation has fallen back materially, prompting us to move to a buy rating.
For the big players, free cash flow yields are looking better after a middling period in the 2010s, which is one reason we have stuck with our buy call on BT. And after big falls in recent years, attractive valuations are there to be had for investors, taking account of the debt dangers from higher rates.
Consumers keep spending
UK economic indicators now provide a very mixed picture, which means an uncertain outlook for UK leisure and retail shares – even if both they and the underlying data have outperformed expectations over the past year. Consumer confidence fell in July after rising for six months on the trot, with wallets under pressure from soaring mortgage costs and elevated food prices. Low rates encourage leisure and retail spending. Debit and credit card spending was flat in the latest figures from the Office for National Statistics (ONS). And as HSBC analysts pointed out in an August report, leisure shares have recently underperformed the FTSE All-Share index.
But a tight labour market, with the unemployment rate sitting at 4 per cent, still supports a rosier outlook for spending. Growth in regular pay was 7.3 per cent in March to May, according to the ONS. With UK retail sales volumes rising by a better-than-expected 0.7 per cent in June, the future could again be brighter than many have expected, even given the hits to income from higher rates – and the fact that retail sales subsequently suffered a weather-related hit in July.
Shore Capital argued that “non-discretionary retail, affordable treats, and big-ticket consumer services (especially travel) are likely to outperform in the short-to-medium term [given] now stronger discretionary goods retail headwinds. [And] we still feel UK living standards will rise around the turn of the year”.
There is much evidence of strong demand despite rate pressures. Recent results have shown that consumers are still splashing out despite spending restraints. We like Premier Inn owner Whitbread (WTB), with its estate benefiting from a squeezing of hotel supply and its pricing model clearly attractive to consumers in this macro climate. We also rate Next (NXT) a buy; the company raised its full-year pre-tax profit guidance by £10mn after full-price sales in its second quarter increased 6.9 per cent. And despite a recent share price wobble, we think Greggs (GRG) is a standout food retailer with a leading margin and return on operating capital employed postings. Hungry shoppers are still queuing up for sausage rolls.
The stubbornly resilient UK consumer environment has even led Shore Capital to ask that “with base rates plateauing, rising living standards [on the horizon] and fulsome employment, could things only get better…?” An intriguing question for investors, despite continuing headwinds.
Airlines, meanwhile, have been posting record results despite the impact of higher rates on debt levels. Holidaymakers are flocking overseas and a significant fall in the cost of fuel is flowing through to income statements. We recently upgraded our view to buy on British Airways owner International Consolidated Airlines (IAG), which pivoted from a loss to over €1bn in profits, year on year, in its half-year results. One impact of higher rates is that the company’s legacy pension schemes are now fully funded. Budget airlines easyJet (EZJ) and Wizz Air (WIZZ), meanwhile, have revealed notable upticks in passenger numbers in recent updates.
Deutsche Bank is overweight on travel and leisure, its preferred services sector, for which it argued that "high earnings growth should compensate [for] rising interest expenses from high leverage".
But debt and rate pressures are very much alive for many companies in this area. While cruise operator Carnival’s (CCL) share price has soared this year, its debt load is a big red flag. The company’s principal payments on outstanding debt will hit $4.5bn by 2026, and the net interest expense in the six months to 31 May this year was a very chunky $1.04bn.
Rate expectations
There is still a significant amount of uncertainty ahead when it comes to the path of rates. The consensus view among analysts is for rates to fall across 2024 and 2025, but to remain above 3 per cent in the US, UK and eurozone (see chart). The market has consistently underestimated how far rates would rise in this cycle, which doesn't inspire much confidence in these forecasts. Either way, these projected positions are still significantly higher than the borrowing costs to which economies had become accustomed (or addicted) to in the recent past, suggesting that investors shouldn’t count on a quick retreat back to easy money.
This has long-term implications for asset valuations. As Liberum investment strategist Joachim Klement notes, “in essence, what we saw in the decade between 2010 and 2020 was what you would expect in a low interest rate environment with global financial markets and no capital restrictions. You create high-flying financial assets and persistently high valuations that look nothing like the valuations we knew in the past.”
Now we are in a very different macroeconomic environment, those assumptions are under pressure. Investors need to consider how higher-for-longer rates will impact these valuations, but at the same time be careful to consider a variety of factors before refreshing their equity holdings.
