Holly Cassell, assistant manager of the Neptune UK Opportunities Fund and UK Mid Cap Fund comments on the implications of a rate rise for UK equities.
With the Monetary Policy Committee members now viewing the decision to raise UK interest rates from historic lows as more finely balanced, and Mark Carney indicating that rates could rise as early as the turn of this year, the timing of an increase in UK interest rates is creeping steadily closer.
The UK consumer is extremely sensitive to changes in interest rates given two key structural features of the UK mortgage market: firstly, the prevalence of short-term variable rate mortgages; secondly, the sheer quantum of mortgage debt, with mortgage payments taking up on average well over a quarter of disposable income for UK homeowners. These factors make the path of interest rate rises more important than their timing, and are well understood by policymakers. As a result, we expect that regardless of when the first rise is announced, the eventual trajectory of rate rises will be very gradual so as to minimise their impact on consumer spending.
While increasing rates will undoubtedly have some effect on consumers, it is important to note that any rise is in fact a symptom of health in the underlying economy; an indication that the Bank of England views the UK’s recovery as robust and well-entrenched. Rising real wages, as we have started to see in recent months, should in part offset the mortgage effect. Specifically in relation to equities, improving corporate earnings should provide support to currently elevated valuations, and the deferral of the government’s austerity plan, signalled in the Summer Budget, should also encourage growth, favouring equities over bonds at the margin.
Based on our monetary policy expectations, the Neptune UK Opportunities Fund holds high conviction positions in stocks which, as well as exhibiting strong fundamentals, are also beneficiaries of rising interest rates. A good example of a company held partly on the rationale of rising rates is Tullett Prebon, the interdealer broker. In addition to its interest rate sensitivity, the company also has an interesting self-help angle with a new CEO appointed last year following five consecutive years of declining earnings. The stock traditionally trades at a discount to peer ICAP based on the latter’s reduced exposure to the structurally challenged voice broking business. However, in spite of Tullett Prebon’s potential to ‘catch up’ with its rivals in the more attractive electronic broking segment, this discount has widened over the last 12 months, leaving Tullett Prebon looking particularly attractively valued in our view.
In general, our fund positioning reflects our cautiously optimistic outlook for the UK market: while fully invested, our approach is one of balance, favouring structural growth sectors like healthcare over high momentum parts of the market such as the housebuilders where, in our view, stocks appear overvalued and therefore vulnerable to policy developments.