When debating what kind of portfolio is going to be best suited to an environment of ‘higher-for-longer’ interest rates, looking at past periods of high rates provides a partial guide.

In the UK interest rates were high and stayed high pretty much from the start of the 1960s all the way through to 1990 and during that period not only were rates in double digits but so was inflation. The difference being that levels of indebtedness among households and businesses were typically lower so this cost of borrowing was easier to absorb.

To complement a look back at what did well during other periods of high rates, we have also sifted through the latest surveys and long-term return forecasts published by the big investment houses to see what the experts think we should own.

WHAT WORKED LAST TIME ROUND?

While interest rates were relatively high throughout the 1960s, 1970s and 1980s compared with the 1990s onward, the period which looks most like today – and which most readers will be able to relate to – is probably the late 1980s.

UK inflation started the period around 6%, dipped to around 4% from 1986 to 1988 and spiked above 10% in 1990 as oil prices flew on the back of the invasion of Kuwait.

Relative to inflation, interest rates were far more punitive than they are today, starting the period at 11% and ending it at almost 15%, as anyone who had a mortgage at the time will remember only too well (in retrospect, it’s easy to see why the period of falling interest rates from 1990 onwards has become known as ‘The Great Moderation’).

In stock market terms, even though the period includes the crash of 1987, which again those who experienced it at the time are unlikely to forget, it wasn’t all doom and gloom as the FTSE All-Share managed a gain of more than 40% by the end of 1990.

The best-performing sector was energy, although this was largely due to the invasion of Kuwait in early 1990 which saw Brent crude prices soar.

Health care and technology also performed well, but every other sector underperformed the benchmark with consumer services (which covers pubs, restaurants and hotels along with airline and gambling stocks) actually making a small loss.

Financials, the one sector which we might have expected to outperform, only managed a 25% gain, well behind the index.

WHY BANKS ARE STILL A BAD BET

Despite investors falling over themselves to own financial stocks the minute central banks started tightening, recent results have shown that higher interest rates aren’t the big boon everyone expected.

As the IMF (International Monetary Fund) explains in its ‘latest Global Financial Stability Report’, published last month: ‘Rising rates are a risk for banks, even though many benefit by collecting higher interest rates from borrowers while keeping deposit rates low. Loan losses may also increase as both consumers and businesses now face higher borrowing costs—especially if they lose jobs or business revenues.’

‘Besides loans, banks also invest in bonds and other debt securities, which lose value when interest rates rise. Banks may be forced to sell these at a loss if faced with sudden deposit withdrawals or other funding pressures. The failure of Silicon Valley Bank was a dramatic example of this bond-loss channel.’

The IMF has identified 30 banking groups with low capital levels, accounting for 3% of global bank assets, which could be vulnerable under its base case for economic growth, but if high inflation were to combine with a 2% global economic contraction that number would rocket from 30 to 153 and account for more than a third of global bank assets.

COULD THERE BE A ‘CREDIT EVENT’?

The IMF’s reference to Silicon Valley Bank is significant, because in March this year there were genuine fears the rapid rise in bond yields could cause a collapse in a group of regional US banks which had taken on too much interest-rate risk.

Ever since central banks started raising interest rates in 2022 there has been a worry that something in the economy will end up breaking, specifically something in the financial system, to cause what is known as a ‘credit event’.

In an interview with Bloomberg last week, James von Moltke, chief financial officer of Germany’s biggest lender Deutsche Bank (DBK:ETR), said the likelihood of higher rates causing ‘accidents’ in the financial sector was ‘a certainty’.

If we go back to 2008 and the great financial crisis, the ‘accidents’ were the failures of Bear Stearns, Lehman Brothers and Merrill Lynch, which had to be bailed out after taking on excessive risk during the mortgage boom, as illustrated by Michael Lewis in his seminal book The Big Short.

Further back, the collapse of hedge fund Long Term Capital Management in 1998 was another ‘credit event’ – although it wasn’t a bank, it had borrowings of $100 billion and had written thousands of derivative contracts with every bank on Wall Street to the tune of over $1 trillion (Roger Lowenstein’s book ‘When Genius Failed’ is an excellent account).

If LTCM had defaulted, the risk would have passed to the banks who were on the other side of its trades, many of whom had also put cash into the firm to start with and would be left facing huge losses.

In both cases, the solution was to absorb the losses by taking over the bankrupt firms allowing time for the incredibly complex web of derivative products to be unwound without creating a market meltdown.

So where are the risks in the financial system today? One obvious answer is China, where one real estate firm after another has defaulted on loan interest payments after over-extending themselves.

Previously it was unthinkable that the Chinese leadership would allow a bank or property company to go bust, due to the effect it would have on confidence inside and outside the country, but leader Xi Xinping has made clear his distaste at the rampant speculation in the real estate market so the jury is out on whether there could be a significant failure.

Without wishing to sound glass-half-empty, we suspect that ultimately the unprecedentedly sharp rise in interest rates will result in a ‘credit event’, because human nature being what it is some firms will have been too greedy and taken on too much risk, and as Warren Buffett famously commented, only when the tide goes out do you learn who has been swimming naked.

WHAT DO THE EXPERTS THINK TODAY?

The current ‘house view’ on the global economy and the trajectory of interest rates from Aviva Investors, the investment arm of the UK’s largest insurer Aviva (AV.), is that headline inflation in the UK, the US, the Eurozone and Japan will ease from their 2022/23 highs to somewhere between 2% and 3% by the end of 2024.

Core inflation, which excludes more volatile prices such as food and energy, is forecast to converge from highs of 6.5% in the US and 7% in the UK to around 2.5% by the end of next year.

However, central banks have made it clear that until inflation returns to low single-digits they will keep rates high, to head off the risk of a resurgence in prices, so real interest rates – that is, the difference between nominal interest rates and inflation – are likely to stay above 2% for the foreseeable future.

In terms of asset allocation, Aviva Investors recommends an overweight position in stocks, with plenty of exposure to the UK, the US, Europe and Japan but low exposure to emerging markets and the Asia-Pacific region excluding Japan.

Conversely, the managers recommend underweighting government bonds, especially in the US and Japan, as ballooning budget deficits in both countries mean they will need to issue vast quantities of debt at higher rates than at present.

In terms of corporate credit, only US and European high yield securities get an overweight recommendation, with investment-grade bonds in the US, Europe and Asia seen underperforming and emerging market debt seen as potentially worrisome.

The multi-asset team at JPMorgan Asset Management has a neutral view on stocks but admits the recent sell-off in equities ‘is bringing market levels closer to a more attractive entry point’.

‘Bulls and bears alike tend to agree that margins are elevated. We also note significant variance in margins – and in turn earnings – by sector and by region. At a regional level, we see further rerating potential in Japan, strong cash flow generation in the U.S. and cheap access to high dividends in the UK,’ they contend.

In terms of government debt they favour UK gilts and European bonds, while in corporate credit they prefer investment grade to high-yield as a means of adding beta to portfolios together with an income stream.

Chris Forgan, multi-asset manager at Fidelity, argues a defensive mix of investments is the best strategy in the face of higher-for-longer rates.

‘Although higher rates are yet to meaningfully dent economic activity in the way many assumed they would, we strongly believe that they will eventually weigh on economic growth, and that the longer they persist, the bigger this impact will be,’ says Forgan.

He recommends lower-risk assets such as cash and high-quality bonds, together with defensive, ‘value’ stocks such as US utilities, income funds and potentially gold.

However, he advises caution when it comes to corporate credit and particularly high-yield bonds given many companies will need to refinance their bonds at higher rates in the coming months and years, which will put the weaker firms in danger of having their credit rating downgraded or defaulting on their debt.

WHAT GOES UP, MUST COME DOWN

In terms of what could bring interest rates down, Fidelity’s Forgan cites the stickiness of core inflation, the tightness of labour markets and the strength of economic growth.

If core inflation remains sticky, and the labour market remains tight as it seems to be in the US at the moment, fuelling wage hikes and demands for higher pay, then central banks are likely to want to hold rates higher longer than may be good for the economy or markets.

Only signs of a significant slowdown might prompt them to alter course, by which time it could be too late, but this is the balancing act central bankers have set themselves over the next year or two.

JPMorgan Asset Management’s multi-asset team believes the risk of what they call ‘the most widely-anticipated recession in history’ actually coming to pass is easing.

‘Convention dictates that restrictive rates for a prolonged period will eventually cause something in the economy to break. However, the imbalances that often help trigger recessions are notable by their absence or at least by their heterogeneity – stresses in one sector do not necessarily cause the dominoes to fall elsewhere.

‘The result is that, broadly, the economy is less interest rate sensitive than many had assumed. At a more granular level, various stresses pass sequentially from one sector or region to another, leading to divergences in margins, earnings and valuations. In turn, this is generating relative value opportunities across assets and across securities but failing to deliver the synchronised slump so many had feared.’

INVESTMENT OPTIONS

Assuming rates do remain higher for longer, then you might want to consider a balanced fund, with decent diversification across different asset classes to provide some ballast to your portfolio. We like JPMorgan Multi-Asset Growth & Income (MATE). Given the greater complexity of managing a portfolio of diverse assets, its charges are a little higher than a straightforward equity fund at 1.07% but it has delivered a three-year annualised return of 8.3%. The yield is decent at 5.3%. It invests in everything from stocks to high yield bonds, government debt and infrastructure. The shares trade at a 1.6% discount to NAV (net asset value).

More cautious investors might look at Ruffer Investment Company (RICA), also trading at a modest discount to NAV (-4.9%). It has a clear remit of not losing money in any 12-month period and growing investors’ wealth over the long haul. The trust is very cautiously positioned with more than 40% of its holdings in short-dated bonds or cash as of the end of September. While it has struggled in 2023 because it has not been invested in the US tech names that have accounted for nearly all the stock market’s gains it is well placed should there be a big downturn in markets. Ongoing charges are 1.08%.

From a sector perspective, health care has performed during previous periods of high rates and tends to be fairly insulated from both fluctuations in the economy and central bank decisions. The one caveat is public finances are under pressure, however health spending tends to be prioritised. Low-cost exposure to the health care space can be achieved through Xtrackers MSCI World Health Care (XWHS) which has an ongoing charge of 0.25%. It tracks a basket of 141 health care stocks in developed markets.

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