Bond proxies and property set to win in low interest market

‘Bond proxies’ such as utilities and real estate stocks could be set to benefit from a low-rate environment after the decision not to raise the base rate split investors on where monetary policy is heading.

The Bank of England’s Monetary Policy Committee (MPC) announced it would be holding the base rate at 0.5 per cent at its May meeting, after speculation earlier in the year that it would begin its hiking cycle this month.

However, the news came as little surprise to investors with markets barely reacting, although sterling slightly weakened against the US dollar.

The decision has certainly divided opinion over what the future holds for central bank policy. Some analysts had expected the Bank to begin hiking this year, while others believe rates will remain constant for 2018.

This is in stark contrast to last month when investors were more aligned in how they saw the market outlook for 2018.

“Just a few weeks ago, we - and the market - had been expecting a 25 basis points increase in the bank rate at this meeting. But a string of disappointing data in recent weeks has thrown the Monetary Policy Committee off this course,” said Karen Ward, chief market strategist for the UK and Europe at JP Morgan Asset Management.

“Although the labour market still looks incredibly strong, with unemployment at multi-decade lows and wage growth picking up, Q1 GDP was weak - growing just 0.1 per cent over the quarter. Data on consumer lending, retail spending and the housing market has also been soft,” she added.

Some analysts are expecting the UK to fall in line with the global economy as it goes through a synchronised monetary policy tightening cycle.

Market expectations for rate tightening cycle

Alex Brandreth, deputy chief investment officer at Brown Shipley said: “While interest rates remain unchanged, it does look like policy direction is going to change in the near future and we believe a period of interest rate hikes lies ahead for the UK.

“The current backdrop of global growth is the most synchronised it has been for almost 10 years and the subsequent spill over from this will inevitably affect the UK economy.

He added: “Those looking for interest rate movements should point their gaze to August and November as these meetings are accompanied by the quarterly inflation report. November seems a particularly sensible month to move as we’ll have found out the decision on the UK’s divorce settlement from the EU by October and the Bank can make any decisions with this in mind.”

However, Hargreaves Lansdown’s senior economist Ben Brettell doesn’t believe interest rates will increase this year, which should create an opportunity for investors.

“Personally, I think we might not see a rate rise for the rest of the year,” he explained. “But while savers will be disappointed, it’s pretty good news for investors. Stock markets don’t tend to like rising interest rates much, so an environment where rates rise only gradually should be supportive for the UK stock market.”

AJ Bell investment director Russ Mould added that ‘bond proxy’ stocks may benefit from a continued low rate environment.

“Utilities may benefit from their perceived status as a bond proxy and an alternative source of income to government –  or corporate –debt. This is partly because expectations for base rate policy influence the yield on offer from the UK’s benchmark government bond, the 10-year gilt,” he said.

“If investors think the Bank of England is going to increase interest rates, then bond yields tend to rise, as investors demand a relatively higher return for lending to the government, to compensate themselves for the –  admittedly small – risk they will not get their money back.”

Indeed, over the last decade, as extraordinary monetary policy has sent interest rates to record lows in the UK, the government bond yield has collapsed, as the below chart shows.

Performance of index over 10yrs

Source: FE Analytics

“And if government bond yields rise, then investors will in turn demand a higher yield from utility stocks to justify the risk of buying or holding them – and that means they tend to sell utility stocks,” Mould added.

On Thursday, the 10-year Gilt yield fell to 1.42 per cent after the announcement and the drop in Government bond yields could make the yield available from utilities seem relatively more attractive, he said.

“Investors may remain wary of Centrica after its November profit warning, with the yield in ‘too good to be true’ territory but National Grid, given its substantial exposure to US assets, may be an interesting hedge against both a weaker pound and increased regulatory or political intervention in the UK,” he noted.

Mould (pictured) also sees an opportunity for real estate stocks, which he said remain unloved.

Indeed, the sector has been hit particularly hard following the Brexit result in June 2016. As a result the FTSE All Share Real Estate Investment & Services index has lagged the broader FTSE All Share by 16.67 percentage points over the last three years, losing investors 6.28 per cent.

Performance of indices over 3yrs

Source: FE Analytics

The investment director said: “Investors tend to fear that higher borrowing costs will weigh on the economy and demand for sites, as well as crimp the real estate investment trusts’ profits and ability to increase their dividends owing to increased interest bills, even if the big REITs have generally worked hard to rein in their loan-to-value ratios from the lofty levels seen a decade ago, just as the financial crisis broke.

“In some cases, the REITs also offer a juicy dividend yield and the sharp drop in the 10-year gilt yield could again highlight the potential value of these payments to income-seekers,” he added.