The outlook for interest rates: A global view

16 March 2018 | Markets and Economy


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Commentary by Peter Westaway, Vanguard chief economist, Europe and head of Investment Strategy Group, Europe, and Shaan Raithatha, Vanguard economist.

Vector image of a globe with a magnify glass

After a surprisingly calm investment environment last year, financial market volatility returned with a vengeance at the beginning of 2018. From the last week of January to the second week of February, global equities dropped 10%, marking the first stock market correction since early 2016.1

What caused this sudden sell-off? Some market participants have suggested that, after a strong run in recent years, this was just an inevitable consequence of an overvalued equity market. Others blamed market technicals (the data generated by market activity) for exacerbating the decline, pointing to the forced selling of algorithm-led trading strategies (strategies that are pre-programmed to make trades in response to certain conditions).

There is likely an element of truth to both of these explanations. But the primary trigger for the fall in global equities lies with investors' concern that global interest rates are set to rise faster than previously expected. In fact, global bond yields (which move inversely to bond prices) started to rise sharply a few weeks before the stock market began its decline. For example, the yield on the 10-year US Treasury note has increased by about 50 basis points since the start of the year, standing at 2.9% as at 19 February 2018.2

The prospect of global monetary policy normalisation, bringing with it the likelihood of higher interest rates, could be considered a headwind for equity market performance. This is because higher interest rates will likely slow the growth of the economy and consequently corporate earnings; and will also result in investors discounting future dividends more heavily.

The effect of higher interest rates

But despite this, Vanguard does not believe that higher global interest rates are much cause for concern, particularly for long-term, globally diversified investors. First, interest rates are still expected to rise in a very gradual and predictable manner and to a lower endpoint than we've experienced historically. This slow and low interest rate cycle should not lead to too much financial market disruption over the long term.

Second, rising interest rates are a direct consequence of a healthy global economy. Unemployment rates have fallen significantly across many markets and policymakers no longer see the need for emergency monetary stimulus. Instead, the attention of central banks is shifting towards the rising risk of inflation. As the experience of the 1970s illustrates, uncontrolled inflation can be as destabilising to the real economy as a full-blown debt crisis. Raising interest rates slowly from emergency levels is likely to be a prudent way of maximising economic growth over the long run.

Finally, most of the fear around higher interest rates is focused in the United States. The US is further along in its economic cycle and is where inflationary pressures are most likely to first emerge. The US Federal Reserve has been raising interest rates since 2015 and is expected to hike rates at least three more times this year.

However, in the UK, the Bank of England has only just started to raise rates and is expected to normalise monetary policy at a much more gradual pace than the Fed given the considerable uncertainty surrounding Brexit. Meanwhile, the euro area recovery is further behind still. The European Central Bank is widely expected to stop quantitative easing by the end of this year and is only likely to start raising interest rates from mid-2019 at the earliest.

How should investors respond?

The current market environment remains very challenging for investors. A slow and low interest rate environment, coupled with elevated equity valuations, implies that future long-term returns across asset classes are likely to be very subdued relative to history. At the same time, as central bankers gradually withdraw monetary stimulus and policy normalises, average market volatility is also likely to rise. With lower expected returns and the potential for more frequent periods of market turbulence, we advocate that investors: 

1. Remain disciplined: Investors should stick to their long-term investment strategies and avoid being swayed by bouts of market volatility. Patience will be key.

2. Stay diversified: Balanced and globally diversified portfolios of equities and bonds will enable investors to better navigate potential market volatility.

3. Be realistic: Future asset class returns will probably be lower than we have been used to in recent years. It would not be prudent to chase slightly higher returns as this could come at the expense of much higher risk.

1 As proxied by the MSCI AC World Index.
2 Source: Bloomberg.


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The opinions expressed in this article are those of the individual authors and may not be representative of Vanguard Asset Management, Limited.

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