By James Butterfill, head of research and investment strategy at ETF Securities

James Butterfill, head of research and investment strategy at ETF Securities.

A major inflection point for global interest rates will be reached during 2017. After almost a decade of artificially low rates, central banks might finally be able to pursue a more balanced approach to setting interest rates without fretting over major political and economic instability.

After an unprecedented term of loose monetary policy, the speed at which we reach this inflection point and the intensity at which central banks can normalise interest rates is dependent on a number of upcoming risks.

The rise of populism and the potential reversal of globalisation could further stoke inflationary pressures which may stunt central banks’ return to “normal”. In addition, the US Federal Reserve (Fed) has already been too slow to tighten and with so much government debt, central banks’ return to “normal” will be a challenge. We believe the most likely outcome will be further cautious monetary policy tightening by central banks in 2017 and 2018, or else they risk falling behind the curve and having to tighten more aggressively later in the cycle.

Impact on FX

We expect the Bank of England to hike rates in 2017 but not to remove its balance sheet stimulus from the economy, which could present an opportunity for GBP, currently the most undervalued currency in the G10 space, as investors unwind short positions.

Due to dramatic economic improvements and the rise in inflationary expectations we believe that the European Central Bank (ECB) could end its QE programme by year end and tapering stimulus should boost the euro back toward 1.10 in the coming months.

We do not expect a ‘taper tantrum’ and, in contrast to market reaction in the US in 2013, believe that European equity markets will benefit from the pickup in economic momentum.

Central banks will have to strike a very fine balance between the twin dangers of inflation and recession. In the US we believe the Fed will need to become more hawkish in both rhetoric and action later in the year. A tighter monetary policy stance than the market expects could see the USD regain the ground it has lost in H1 by year end 2017.

Weakness

We have isolated companies most vulnerable to interest rate rises by looking at those with the biggest debt burden and are thus cautious on UK large cap equities and US small caps.

The UK has seen a substantial deterioration in its interest cover ratio – a measure of companies ability to handle their outstanding debts – having fallen from 9x in 2012 to just 3.4x today. Anything below 1.5x indicates an unhealthy company that is struggling to handle debt. The FTSE 100 has a lower ratio than the FTSE 250 and within that, the property and resource sectors look particularly vulnerable.

In the US, smaller companies’ interest covers have diverged from large caps. Real Estate Investment Trusts (REITS) are the obvious group of companies in the S&P 500 that are vulnerable to interest rate rises but the oil and gas sector looks weak too, especially after a year of very low oil prices.

Opportunities

Inflation-linked bonds are attractive in recovery and inflationary economic phases and have outperformed all other asset classes over the past ten years, and expect investor appetite to increase as a result.

We believe structural headwinds will continue to exert downward pressures on growth and inflation over the next decade and thus have a preference for emerging market debt and high yield credit.