Beetles to Beatles: the return to higher rates

We Portfolio Managers  do tend to read slightly obscure press releases. This morning I read that German auto stalwart Volkswagen was being demoted from the Euro Stoxx 50 index, losing its spot to brick-phone manufacturer Nokia. VW’s popular car, the Beetle, hit its peak production probably around the time the UK music export the Beatles hit their peak popularity, and in many ways both were symbols of a move to a more connected and richer world.

Back then, it was also a rate hiking environment as we are now in. But think about the today world in which we are shifting away from internationalisation, I found the divergence between central bank policy choices quite interesting. Viewed individually, the latest central bank decisions appear straightforward.

The Federal Reserve raised by 25 base points (bps). The Bank of Japan continued its slow march away from the emergency settings that defined much of the last three decades, also with a 25bps hike. And the Bank of England chose to hold steady, at least for now.

Politics has also returned to centre stage. In the United States, many commentators assumed the Federal Reserve might become more politically accommodating. But new Fed Chair Kevin Warsh bucked expectations that he might just kowtow to Trump’s wishes and voted in favour of a 25bp hike.

Meanwhile in Japan, politics has surfaced in a different way. Two Ministry of Finance-appointed members reportedly opposed the latest rate increase, highlighting the delicate balancing act facing Governor Kazuo Ueda. The Bank of England's decision to hold rates was arguably the least dramatic of the three decisions, but perhaps the most politically sensitive. With an October Budget approaching, the interaction between monetary and fiscal policy will be closely scrutinised and expectations are for a visit from the Taxman.

Indeed, for years, Japanese investors refused near zero returns at home and invested abroad instead. US Treasuries, global bonds and international equities benefited enormously from this flow of capital. Even today, Japan remains one of the largest foreign holders of US government debt – but frankly, there is no need to ‘Let It Be’. Why bother taking foreign bond risk if you can achieve the same yield with neither cost of hedging nor foreign currency risk. The $1tn Japanese Government Pension Investment Fund opening door to increasing their portfolio’s share of domestic assets, investors are rightly musing what happens if flows shift in this manner.

The higher rate environment matters for the investment boom surrounding artificial intelligence too. Clearly, AI has helped sustain growth, support employment and the massive cash flows and earnings have propelled equity markets higher. As the financing needs have increased, concern around corporate bond financing crowding out government spending has also increased. We know AI is going to be transformational to many businesses: but not all business will justify expectations built during an era when capital was extraordinarily cheap.

The higher rate environment will mean new trade offs and considerations are necessary for investors when building portfolios. It is working out, in a world where money once again has a cost, which investments will still be ‘Here, There and Everywhere’.