The pain of rising interest rates

Global supply chains are yet to normal following the Covid pandemic with an ensuing scarcity of key products and components driving up costs. Meanwhile, the war in Ukraine has hit energy and food prices. The combined result has been rocketing inflation reaching heights in Western economies not seen since the 1980s. Consumers and businesses have been feeling the pain. 

Investors have been suffering too as central banks have reacted with the fastest tightening cycle in decades. Although some feel they could have acted more swiftly and decisively, central banks around the globe have been hiking interest rates at an aggressive pace as they seek to stave off inflation amid fears it could become embedded. By raising rates, central banks hope to discourage investment and spending and thereby dampen economic growth and, crucially, inflation.

In little over a year, the Federal Reserve – the US central bank – has raised interest rates from close to zero to a current range of between 5% and 5.25%, the highest since 2007. Over a similar timeframe, the European Central Bank increased its main interest rate from -0.5% to 3.5%, the fastest tightening since the creation of the single currency. The Bank of England's interest rate currently stands at 5% from just 0.25% at the end of 2021. Markets are pricing in more hikes before the year end.

At the same time, with the exception of Japan, the last of the remaining quantitative easing programmes – where central banks print money to underpin flagging economies – have been all but reversed, thereby removing another vital support to bond and equity markets.  

The burning question for investors now is when the current tightening cycle will come to an end as cuts in rates are usually accompanied by a rally in equity and bond markets. Falling rates could also prove supportive for art markets as lower rates could encourage collectors to move money out of their savings and into art and collectables. 

Clouding the outlook are risks in the banking sector (an argument for holding off on further rate rises or even for cutting rates) and inflation which is receding more slowly than hoped in some Western economies (an argument for hiking rates).  

While some further interest rate rises are certainly likely – particularly as not all central banks are at the same stage in their hiking cycles – most analysts believe interest rates are now at or close to their peaks. Following banking turmoil in the US and Switzerland, investors trimmed their expectations for global interest rate rises with interest rate swaps briefly indicating that many of the world’s major central banks will not raise rates further. In some cases, swap rates indicated that central banks will begin cutting rates before the year end. Since then, amid signs that inflation is proving more stubborn, markets have begun pricing in further rate rises this year.  

Below we look at key investment asset classes showing how they have performed in the current tightening cycle and how they might be impacted by future interest rate decisions.'

Art and collectables 

Most art dealers and advisers do not believe the art market is too affected by interest rates. But when rates climb to very high levels, like in the late 1980s when Bank of England base rates touched 15%, this can affect sentiment as some investors and collectors instead choose to put their money in the bank.

Rates have climbed rapidly – albeit from very low levels – in recent months. But investors looking for clear signs that the art and collectables markets were impacted will be disappointed.

Last year was characterised by auctions of a number of single-owner collections, including works by Microsoft founder Paul Allen and US investor Anne Bass. Such single-owner sales at Christie’s, Sotheby’s and Phillips totalled almost $2.7bn in 2022, a five-year high. Total sales of fine art reached $15.9bn in 2022, according to Artnet, down slightly against 2021 but still the second-highest total since 2018.  

The Knight Frank Luxury Investment index, which covers art and collectables such as cars, watches, and wine, rose 16% in 2022, led by art up 29% and followed by cars 25% higher. Such performance strongly supports the theory that art is a store of value during uncertain financial markets.

With rates likely to stabilise towards the end of 2023, the interest rate environment is unlikely to influence art markets much. Of far greater importance will be geopolitical concerns and the economic outlook.

Equities 

Since the beginning of 2022, the approximate start of the current tightening cycle, to the end of April 2023, the FTSE All World index of global stocks is around 13% lower. Last year, US stocks had their worst year since 2008 with the S&P 500 basket of leading stocks down over 19% and the tech-heavy Nasdaq index down a third. Geopolitical concerns and fears of recession clearly weighed on stocks. But rising interest rates also played a major role – particularly for growth companies like tech stocks – as their valuations using discounted cash flow models are particularly sensitive to interest rates. 

Going forward, from the protracted war in Ukraine to possible – albeit receding – risks of recession, perils remain for stocks and shares. But with inflation expected to continue to fall and pivots from major central banks on the horizon, there is reason to hope that stock market volatility will be significantly lower in 2023.

Bonds

During a period of rapidly rising interest rates, it is hardly surprising that bond investors have been hammered. Over 2022, the FTSE World Government Bond index, consisting of the sovereign debt of over 20 countries including the US, Japan, and the UK, fell over 18%. In reaction to rising interest rates, yields on benchmark 10-year US Treasury bonds have climbed from around 1.5% to over 3.65% in the 16 months to mid-May 2023. For holders of these bonds, this has meant losses as when bond yields rise their capital values fall.  

According to Edward McQuarrie, an investment historian and professor emeritus at Santa Clara University, last year was the worst year on record for the US bond market, reflecting in great part the speed and depth of rate rises. Unusually, bonds and equities fell in unison, a rare occurrence that has only been witnessed 2% of the time since 1926, according to Goldman Sachs.

Today’s higher bond yields provide investors with a bigger buffer to absorb any further interest rate increases. With possible rate cuts in sight, 10-year benchmark bond yields could actually fall over 2023, providing modest gains for bond investors. What is almost certain, is that the worst for bond investors is now behind us. 

Property 

Interest rate rises are generally not good for property returns as the majority of property purchases are funded by debt. Rising borrowing costs deter new investors, in turn driving down prices.

Yet rising rates are not always bad news as they are frequently accompanied by strong economic growth and low unemployment, both positive factors for property prices and rents. It’s just that, over this last year, rate rises have coincided with a deteriorating economic outlook, a bad recipe for the sector.

Over 2022 the FTSE Nareit All Equity REITs index, which covers US commercial real estate, posted a total return of -24.9%. UK property fell 10.4% last year according to MSCI’s monthly UK property index, with most of the declines coming in the second half of the year as interest rate rises started to bite. Even so, it was still possible to make money from property in 2022 and returns varied widely with commercial offices amongst the worst hit.

Few are predicting a strong rebound in property prices this year. But with interest rates expected to level off, some stability should return to the property market in 2023.