The grey clouds hanging over Credit Suisse’s London-based office perfectly captured the mood on a day in mid-February 2016 when Elroy Dimson and Paul Marsh sounded a note of caution to investors. The Emeritus Professors of Finance from London Business School (LBS) delivered a downbeat message while presenting the findings from their 2016 Global Investment Returns Yearbook.
The big talking point is that interest rate hikes can damage the wealth of investors with stocks and bonds in their portfolios – a significant development in light of the Federal Reserve’s announcement on 16 December 2015. That day, the Fed raised the US interest rate to 0.5% in what many financial experts believed would lead to further hikes throughout 2016.
Research for the 2016 yearbook – authored by LBS’s Dimson, who also chairs the Newton Centre for Endowment Asset Management at Cambridge Judge Business School, Marsh and Dr Mike Staunton, Director of the School’s Share Price Database – is based on the investment returns of 23 national stock markets since 1900. The latest edition, now in its 17th year, focuses on the interest-rate sensitivity of 12 financial assets including equities and bonds, 12 industries and 12 asset classes such as gold, property and artworks.
Lessons from history
When studying US interest rates between 1913 and 2015, the authors found that an initial rise following a period of financial instability often led to a hiking cycle. In the 1920s and during the 1950s and early 1960s, rates climbed from around 3% to 7% and below 1% to just under 2% respectively. More recently, the Fed increased the interest rate from around 3% to above 6% during the 2000s. A similar pattern emerged in the UK throughout the same periods.
“Until late last year, no American or British investment professional in their 20s, and not many in their early 30s, had ever experienced a hike in their domestic interest rates,” says Marsh when discussing results from the yearbook, which features analysis of 70,000 days of financial market history. “This is really a unique event; US and UK interest rates have been exceptionally low for longer than almost any period in history.
“A rate hike affects bond and equity markets; they react immediately and in anticipation of rate rises, which changes portfolio values. If rate hikes are bad news for equities and prices fall, that makes us all poorer, leading to a wealth effect. We then want to spend less, because we feel poorer.”
Long-term bonds also suffer when interest rates rise. While central banks only have control over short-term interest rates, they still influence the prices of government bonds with longer maturities. This, in turn, affects long-term borrowing rates on mortgages and loans.
We have an announcement
An interest rate rise can have an immediate impact on bonds, equities and currencies. On the day of a hike announcement, equities fell by an average 10 and 49 basis points in the US and UK respectively. Bonds also dropped, by 8 basis points in America and 31 in Britain. Conversely, the US dollar and British pound climbed by 12 and 5 basis points.
Cutting rates has the opposite effect, with bonds rising by 23 and 12 base points in the US and UK. Meanwhile, the dollar and British pound fell by 26 and 5 base points on the day that a rate decrease was announced.
Whether going up or down, the performance of bonds, equities and currencies in the run up to and on the day of a rate-related announcement is rarely surprising. Central banks make their intentions clear in the weeks or months before a rise or cut, giving investors a sign of what to expect.
“A rate change could be triggered by pre-announcement market conditions, so the behaviour of the market over the preceding 20-day period depends on a variety of factors,” the yearbook says. “It seems unlikely that declining equity markets would trigger a rate hike, so it is more likely that equity and bond markets anticipated the policy tightening – through central bank communication or some data events – which caused the losses in the run up to tightening.”
While increased rates may be bad for bonds and equities, they give economists cause for optimism. Marsh says that rates tend to climb for two reasons: the economy is strong enough to withstand the increase, or rising inflation needs to be squeezed.
“Does hiking damage your wealth? For that, we have to go back to the reason that central banks tighten and raise interest rates,” Marsh says. “They do it because they are concerned about current or future inflation and want to get in before that inflation takes hold.
“By increasing interest rates, the banks then pass the rise on to consumers and people face higher credit card bills or increased payments on cars or short-term loans. That depresses consumer spending and money supply, which squeezes inflation in the system.”
Rise and fall
Another talking point from the yearbook is risk premia after rate rises and declines. The authors’ research shows that during easing cycles in the US, the equity risk premium (ERP) versus Treasury bills was 8.8% per year – far higher than 1.8% when rates were rising. Meanwhile, the ERP versus bonds was 5.5% in an easing cycle compared with 1.9% as rates climbed.
A similar trend emerged in the UK, where the entire long-run ERP was earned during easing cycles. The ERP versus bills and bonds was 7.6% and 5.5% respectively. In contrast, the figures plummeted to -0.04% and -0.8% during hiking cycles.
The research also looks at how 12 industries in the US performed, relative to the market, from 1926–2015. Defensive, low-risk sectors such as utilities, energy and healthcare provided 1.7%, 2.6% and 4.5% relative returns respectively on investment during hiking cycles. The figures dropped to -2.7%, -0.9% and -0.2% in easing cycles. Conversely, other more risky industries such as retail and consumer durables delivered 3% and 4.1% relative returns in easing cycles compared with -2.1% and -4.4%, when interest rates increased.
The figures for the UK tell a similar story. Utilities and healthcare generated 3.3% and 3% relative returns respectively in easing cycles, but produced greater results (8.5+% and 4.9%) as interest rates climbed. Meanwhile, returns for retail and consumer durables dropped (-3.7% and -6.1) when rates increased and rose 1.4% and 0.3% in a period of easing. These findings are based on analysis spanning 60 years, from 1955 to 2015, rather than 89 years for the US.
“If you find an industry that moves in one direction after a rate fall, you can be pretty confident it will move in the opposite direction after a rate rise,” Dimson says. “You can see the same sort of patterns emerging – industry returns go systematically in the opposite direction between periods of rising and falling interest rates.”
What next for investors?
Whether introducing tighter monetary policy, quantitative easing or cutting interest rates, governments around the world are taking steps to kick-start their economies. For investors in bonds and equities, such measures can affect their returns – but often only when central banks do something unexpected, according to the yearbook.
If that happens, Marsh and Dimson believe investors should still refrain from tactical asset switching. They say using past economic conditions and marketing timing signals to predict future performance is unreliable. Moreover, it costs money to switch assets.
Instead, long-term investors have a few options: they can adapt to lower returns on bonds and equities in the coming years, take on more risk or diversify by adding other assets to their portfolios. “We are in a low-return world and it’s a global challenge,” says Dimson. “Equities do not offer a larger equity risk premium when interest rates are low, so you can’t catch up by investing in them.
“Portfolio returns are expected to be lower in the future than in the past, so you might look at contracyclical securities, but it’s quite difficult to find a business that would do well during a recession. You can take on more risk, but people should be reluctant to do that at a time when returns are low.
“Our take is to focus on diversifying across assets; they tend to move in the same direction in relation to interest rates, but not in exactly the same way. On that basis, diversifying is beneficial. The key message for investors is to focus on how much time you are in the market and not on timing the market.”
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