How a prolonged, higher interest rate shapes asset allocation

It is likely that we are entering a new regime of higher interest rates over a longer period - summed up by the phrase ‘higher for longer’ - a sharp contrast to the ‘lower for longer’ environment that was prevalent in the period after the financial crisis. This has major implications for asset allocation.

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. This is one of the main reasons why we are defensively positioned in the Fidelity Multi Asset Open range. We have a preference towards the defensive areas of the market, such as the US Utilities sector, the Fidelity Global Dividend Fund, and gold.

Key points that investors should be mindful of in this ‘higher for longer’ regime:

1. The increased importance of high-quality bonds in the portfolio: After years of low yields, bonds now offer attractive interest rates, making them more appealing to investors. We have a bias towards government bonds and higher quality fixed income assets in the Open range. Elsewhere, both investment grade bonds and government bonds are part of the strategic asset allocation (SAA) for the Fidelity Multi Asset Allocator range.
2. Being cautious on high yield bonds: The fundamentals of companies in the high yield universe continue to deteriorate. Many issuers will need to refinance their bonds and higher rates in the coming months and years, which will put the weaker companies in danger of having their credit rating downgraded or defaulting on their debt. We remain tilted away from high yield bonds in the Open range, and this volatile asset class is not included in the Allocator range as part of the funds’ long-term exposure.
3. Maintaining an allocation to equities: Higher interest rates make it more expensive for corporates to raise capital. As a result, profit expectations could start to fall. However, the value style stands to benefit from higher interest rates. In the Open range, we have a position in the Polar Capital UK Value Opportunities Fund to take advantage of the favourable conditions for value stocks.

What will influence the path of interest rates?

Our approach to asset allocation will of course depend on the trajectory of interest rates from here. We believe that there are several crucial factors to watch to determine this:

• The ongoing stickiness of core inflation: The core components of inflation remain sticky, despite some recent tapering off in headline inflation numbers. Central banks will be unwilling to cut rates while inflation is elevated.
• The tightness of labour markets: The labour market continues to remain tight in the US with low levels of unemployment. Wage growth stemming from this lack of slack is one of the drivers of inflation that policymakers are most concerned about.
• Any slowdown in economic growth: Any significant slowdown in economic growth might result in central banks changing their course of action. However, they are most likely to wait for more compelling evidence around cooling off in the economy before rushing to change their stance.

Many investors believe that interest rates in the US and possibly Europe have peaked, however if inflation stays elevated in the near term, it remains a possibility that central banks may feel the need to increase interest rates again to ensure inflation returns to their long-term target. In any case, we believe that central banks are unlikely to pivot to significant rate cuts for fear of encouraging spending and therefore inflation spiralling even further.

Diversification and flexibility still key to delivering returns throughout market cycle

Cash and other low-risk assets currently offer decent levels of returns. However, we believe a multi asset approach is still preferable for delivering stable returns across market cycles.

The Allocator range has been designed on the basis of the long-term behaviour of different asset classes, and therefore ignores short-term noise created by market conditions. The economy tends to go through different interest rate cycles – sometimes they are low and sometimes they are high – and the timing of these cycles can vary from one country to another. That is why it is important to diversify your portfolio, not just by asset class but also by region and sector. 

Chris Forgan, Portfolio Manager, Fidelity Multi Asset Allocator and Open ranges

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Important information

This information is for investment professionals only and should not be relied upon by private investors.

The value of investments can go down as well as up and clients may not get back the amount invested. The Fidelity Multi Asset funds use financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for illustration purposes only. Investors should note that the views expressed may no longer be current and may have already been acted upon. The investment policy of these funds means they invest mainly in units in collective investment schemes. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. Investments should be made on the basis of the current prospectus, which is available along with the Key Investor Information Document and current and semi-annual reports, free of charge on request, by calling 0800 368 1732. Issued by Financial Administration Services Limited and FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0923/382319/SSO/NA