UK stocks should cope with rising interest rates better than other markets

We've regularly discussed the notion of long duration and short duration assets here.

To cut a long story short, "duration" is a measure of sensitivity to interest rate changes.

The longer an asset's duration, the more it'll move when rates go up or down.

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Long duration assets have had a great run, as interest rates have been falling relentlessly for years.

But now that's stopped. So what should you invest in instead?

Why long duration assets have done so well

Duration is all about the value of future cash flows. Say you are offered the promise of a guaranteed payout of £10,000 in 10 years' time. How much money are you willing to pay for that promise today?

The answer is: it depends. But if interest rates are 1% today, you'll be willing to pay more than if interest rates are at 10% (for ease of use, we'll ignore inflation as that complicates things). You'll also be willing to pay more in an environment where rates are expected to fall, compared to one in which rates are expected to rise.

Now what would you pay for a guaranteed payout of £10,000 in a year's time? Again, you'll be willing to pay more if rates are at 1% than if they are at 10%. But the difference between those two sums won't be particularly big.

In other words, the value of £10,000 in a decade's time is far more sensitive to changes in interest rate assumptions than the value of £10,000 in a year's time.

So a "long duration" asset is one where the payoff is far away, and a "short duration" asset is one where the payoff is nearby. That's why I sometimes call it a "jam tomorrow" asset.

"Long duration" assets have done really well in recent decades because interest rates have just kept on falling. Now though, interest rates are flipping around and there's a glimmer of suspicion that this might be the end of the secular (ie long-term) trend that saw them fall relentlessly since the 1980s.

That means "short duration" assets are starting to look more appealing. So what does that mean for investors?

How to position for a shorter duration world

Well there's an interesting piece of research highlighted by Joachim Klement in his most recent blog. The research is by Jules van Binsbergen of Wharton business school at the University of Pennsylvania.

Binsbergen's body of research compares long-term returns on bonds with those on shares. It treats shares as long-duration assets and compares their performance with long-duration bonds.

I won't go into the details because it gets quite dense. But in effect, what Binsbergen finds is that if you invest in bonds that have the same duration as equities, the bonds give you the same return but with less volatility.

This research, as Klement points out, raises a few tricky questions. The most obvious conundrum is this one: shares are riskier than bonds. If you lend your money to a developed world government – and certainly to the US – you can feel as sure as you can about anything in markets that you'll get paid the interest and your money back at the end of the term.

The only real risk is the big picture backdrop: what happens to interest rates? What happens to inflation? And all the rest of it.

Shares, on the other hand, carry loads of risk by comparison. Companies are under no obligation to pay dividends. Earnings are subject to the vagaries of the economic cycle, but they're also subject to the vagaries of consumer taste and competition and technological development. They are obviously much riskier than bonds – there is no debate about that.

If an asset carries more risk, then economic theory states that it should deliver greater returns. Why would you take the risk of investing in shares if you could get exactly the same return in bonds?

So it's a bit of a shocker to find that investing in equivalent bonds would have given you a better risk-adjusted return.

Anyway, that's a quandary for another day. What's also interesting about the research is that in a follow-up study, Binsbergen expanded his research beyond the US and into other developed markets. He found the same thing – that equivalent bonds would, in effect, beat equities.

But he also found that different equity markets had different durations. Between the US, Japan, the eurozone and the UK, the US – as measured by the S&P 500 – has the longest duration. That makes complete sense. The US has massively outperformed every other market in recent years and it's also the one with all the hot-but-not-yet-profitable "jam tomorrow" stocks.

What's the one with the lowest (or shortest) duration? You guessed it. The FTSE All-Share.

So if you're looking to adjust your equity asset allocation to cope with a brave new world in which rising interest rates mean shorter-duration assets have their time in the sun, then the solution is straightforward: reduce your US exposure and increase your UK exposure. Which is, of course, pretty much what we've been suggesting you do for a while now.