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Interest rate rise – what it would mean for markets and investors

Laith Khalaf | 1 November 2017 | A A A

You’re about to read press releases, which we’ve written for media use only. They’re not intended for individual investors. They’re not personal advice and don’t include any recommendations.

No recommendation

You’re about to read press releases, which we’ve written for media use only. They’re not intended for individual investors. They’re not personal advice and don’t include any recommendations.

Media contact:

Laith Khalaf

Senior Analyst

Direct Line: 0117 980 9866

Mobile: 07977570820

Email: laith.khalaf@hl.co.uk

  • Rising interest rates – prospects for the pound, equities, bonds, cash, and property
  • Why the pound might actually fall tomorrow
  • A hollow victory for cash savers
  • Winners and losers on the stock market- why banks stand to benefit

Key stats:

  • We estimate 8 million Britons have never seen an interest rate rise in their adult lives
  • £187 billion sits in cash accounts paying no interest
  • £10,000 in a typical cash account in March 2009 is now worth £8,680 in real terms
  • £10,000 invested in the stock market in March 2009 is now worth £31,200, or £25,660 in real terms
  • A 1% rise in yields would lead to an approximate 11% fall in a diversified gilt portfolio

Markets are now pricing in a 90% chance of a UK interest rate rise tomorrow. High expectations on this front have been disappointed before, and even if they aren’t, a rate rise only takes us back up to 0.5%, where we were eighteen months ago.

However the prospect of an environment of rising interest rates is one which investors should be alert to, and what follows are some tips for investors and some thoughts on how tighter monetary policy could impact on asset prices, whether we get a rate rise tomorrow or not. It’s important to note that interest rates rises are set to be slow and steady, and so any change in asset prices is likely to be gradual, and to take place over an extended period.

Laith Khalaf, Senior Analyst, Hargreaves Lansdown:

‘It’s been over ten years since the last interest rate rise, so investors will have to dig deep in their memory banks to remember what one looks like. While a rise in interest rates would mark the start of a new era in monetary policy, we don’t anticipate too much disruption in financial markets, as the tightening stretch of the cycle looks like it will be long and shallow.

Interest rate rises are widely expected, so it’s really any shift in the anticipated timetable for tighter policy that will move markets. This is a two way street, and the path of interest rate rises can shift further into the distance as well as nearer into the foreground. To that end it still make sense to hold a diversified portfolio, in case things don’t go according to the script. Indeed if an interest rate rise doesn’t materialise tomorrow, we could see sterling fall, and gilts rally.

However we still think there’s little value in global bond markets, as the low yields on offer don’t compensate investors for the risks they are assuming. The prospect of rising interest rates throws this into sharper focus, because tighter policy will put downward pressure on bond prices. Perhaps the most concerning aspect here is the high number of people who are blindly defaulted into bonds within their pension plan, just as they are about to retire.

For equity investors, the picture doesn’t change too much. Rising interest rates turn the screw, but they will only happen if the economy is in good enough shape, which would be positive for company earnings. In the scenario of low productivity we face in the UK today, both economic growth and the pace of rate rises are likely to be sluggish.

There could be some individual stocks which fare better than others, with the banking sector probably best positioned to take advantage of rising rates. The flip side of this particular coin is that cash savers probably shouldn’t get too excited just yet.

An interest rate rise is a hollow victory for cash savers because it still won’t deliver a level of interest that keeps up with price rises. Tighter monetary policy will also take its time to filter through to cash savers because the banks will delay passing through higher rates to depositors for as long as possible.

Overall we don’t see much reason for investors to make significant changes to their portfolio. The main thing to check is how your pension is invested as you approach retirement, and if it is shifted into bonds, make sure that’s an appropriate strategy for you, and that you’re happy with the risks.’

UK bonds

Bond prices are in the front line when it comes to potential damage from tighter monetary policy, because they pay a fixed amount of annual interest which looks less attractive as rates rise. Interest rate rises are going to be very slow and steady, which means that bond prices will probably deflate gradually. One can’t entirely rule out the possibility of bond bubble suddenly bursting, but it looks like a tail risk.

Pension investors may not know how big their bond exposure is, as many are defaulted into bond funds as they approach retirement via insurance company lifestyle strategies, with the anticipation that they will sell up and buy an annuity at retirement. Only around 20% of people now do this, thanks to pension freedoms. Around £11 billion is held in these lifestyle funds on behalf of pension investors.

Key stat: The 10 year government bond currently yields 1.4% compared to 5% ten years ago. A 1% rise in yields would mean an approximate 11% % fall in the price of a diversified gilt portfolio.

Tips for investors:

  • Review the portion of your portfolio invested in bonds, which may well have got out of kilter thanks to the tremendous run bonds have been on.
  • These fixed interest securities can still provide useful portfolio diversification, after all, we may not get an interest rate rise.
  • If you are approaching retirement check if you have been defaulted into an annuity protector fund by your pension provider’s lifestyling process. If you aren’t going to buy an annuity, this is an inappropriate strategy and could be heavily exposing your pension to bond market risk at an inopportune time.
  • Where you hold fixed interest investments consider holding them in strategic bond funds, which give the manager the flexibility to invest across the bond spectrum to seek opportunities, and also to protect investors if there is a sell-off.

Cash

Rising interest rates should be good for cash savers, though it’s hard to see much of a material impact for income seekers anytime soon. Looking back to rates prior to the referendum as a guide, an interest rate rise back up to 0.5% would see the typical rate on a cash ISA rise from 0.8% to 1.3%.

While that is a significant jump in relative terms, getting £13 annual interest on each £1,000 saved compared to £8 is unlikely to see consumers rushing to fill their boots. Rates on cash accounts probably won’t rise as quickly as they fell either; banks tend to make more profits when interest rates rise because they don’t pass on hikes as quickly to savers as they do to borrowers. All in all, a rate rise is a somewhat hollow victory for cash savers.

Key stats:

  • The current rate on the typical cash ISA is 0.8%, compared to CPI inflation of 3%, so money in these accounts are losing their buying power to the tune of over 2% a year.
  • The household sector currently holds £187 billion in cash accounts paying no interest, up from £23 billion ten years ago.
  • £10,000 cash has lost £1,320 in buying power since interest rates were cut to 0.5% in 2009; the average instant access account (from Moneyfacts) has turned £10,000 into £10,560 today, but that’s only worth £8,680 after inflation is taken into account.

Tips for investors:

  • Keep a cash buffer as a rainy day fund, around 3-6 months expenditure as a minimum, but for longer term money consider investing in more productive assets, albeit these come with more risk to capital.
  • Shop around for the best cash rates to make sure your money is working as hard as possible for you.

Property

Residential property - an interest rate rise will lead to an increase in mortgage costs which should constrain house price growth. However a 0.25% interest rise alone doesn’t look sufficient to fully offset the two big tailwinds putting upwards pressure on house prices, namely a big supply/demand imbalance and the Help to Buy scheme.

Commercial property – in theory an interest rate rise is a sign of confidence in economic growth, which should be beneficial for commercial property, however while the UK economy is growing, its progress is slow. Rising interest rates do make commercial property yields less attractive in relative terms. However, again a 0.25% rate rise isn’t exactly going to lure many investors into cash, so we wouldn’t expect a mass exodus from the sector, though there may be a steady drip away if bond yields start to pick up significantly, as many have invested in these funds for yield and diversification in lieu of bonds.

Key stats:

  • There is currently £24.7 billion held in open-ended funds in the Investment Association Property sector, up from £6.9 billion in March 2009, when interest rates were cut to 0.5%.
  • Over half of the sector suspended trading in the wake of the EU referendum as funds were not able to liquidate properties quickly enough to keep up with investor sales.
  • The average UK house price has risen by 15% over the last 10 years according to Nationwide, however this growth has been very unevenly distributed, with the average London property price appreciating by 56%, but falling by 4% in Scotland, 5% in the North of England and 41% in Northern Ireland.

Tips for investors:

  • Those who invest in commercial property funds should make sure they are happy with the relatively high costs involved, and are happy to hold for the long term, particularly if invested in an open-ended fund which may suspend dealing in times of distress.
  • Buy to let investors should be wary of the localised nature of the property market, the costs of buying and maintaining a property, and the additional taxation that has recently been added to this kind of investment.

Gold

Rising interest rates are a headwind for gold, though global interest rates, and particularly the US, are more relevant than purely the UK. Gold doesn’t yield anything, and so if cash and bonds start paying more interest, gold starts to look less attractive by comparison.

Tips for investors:

  • Gold is basically a bit of catastrophe insurance for your portfolio, and so shouldn’t make up more than 5-10%.
  • If investing in ETFs, investors should seek out those which are physically-backed.
  • Gold isn’t a one way bet and can be volatile.

Key stat: gold peaked at over $1,880 in 2011 the price has dropped back to around $1,270.

Sterling

The prospects for sterling are not as clear cut as one might imagine, and the Brexit negotiations clearly have a big role to play in the longer term fortunes. Rising UK rates are in theory supportive of the pound but progress for the currency may be thwarted by two factors. Firstly, an interest rate rise has already been priced in to some extent, and actually there is a risk sterling falls if a rate rise fails to materialise tomorrow.

Secondly, the UK is not alone in tightening policy. The US has already raised interest rates 4 times from the emergency rate post-financial crisis, and has started to unwind QE. Meanwhile Europe has recently announced a reduction in its quantitative easing policy, which should ultimately pave the way to its termination and the possibility of rising rates. So there is support for the dollar and the euro too, which may constrain the pound’s appreciation if UK rates do start to rise.

Key stat: The pound is currently trading at $1.33 against the dollar, compared to $1.48 on the day before the EU referendum.

Tips for investors:

  • We don’t see a great deal of value in trying to adjust your portfolio to take advantage of currency movements, which are by their nature unpredictable.
  • Keeping a globally diversified portfolio is one way to get a spread of currencies in your portfolio, however even an investment in the UK stock market comes with a high level of earnings in overseas currencies.

UK Equities

The UK stock market has diversified global earnings streams, so at an aggregate level we don’t foresee a great deal of disruption for rising interest rates here in the UK, particularly given how muted and slow these increases are likely to be.

If we get a big rise in sterling this may knock some of the shine off the stock market, but for the reasons stated above, a rate rise in and of itself doesn’t mean the pound is going to strengthen significantly. Some hawkish rhetoric from the MPC suggesting a sharper tightening of policy going forward might do the trick, but this seems less likely.

Below are some thoughts on a few areas of the stock market which could be affected by increasing expectations of a rate rise. No business is reliant on just one factor for its performance however, and any positive impact from rising interest rates could be offset by other market developments.

Key stat: Low interest rates have been positive for the stock market; since interest rates were cut to 0.5% on 5th March 2009, the UK stock market has turned £10,000 invested into £31,200, or £25,660 after inflation has been taken into account.

1. Banks

The UK banks stand to be key beneficiaries of rising interest rates, because this will allow them to make a bigger margin between the money they take in as deposits and the money they loan out to individuals and businesses. Lloyds and RBS are the two FTSE 100 banks who stand to benefit most from UK interest rate rises, though as stated above current expectations of rate rises will be partly factored into share prices.

2. Companies with large pension deficits

Low interest rates have meant low bond yields, and that’s caused no end of problems for companies with large pension funds, because liabilities rise as interest rates fall. The opposite is true too, so rising interest rates should see the black holes in UK defined benefit plans shrinking.

For instance Tesco’s pension deficit has gone from £603m in 2008 to £5.5bn last year, with the result that Tesco is having to top up the fund to the tune of £285m a year. Similarly Barclays recently announced a £4.5 billion increase in pension contributions over the next ten years to deal with the deficit rising from £3.6 billion to £7.9 billion. However these payment were weighted to the years beyond the next funding valuation of the scheme in 2019, which means by the time they come around, rising interest rates might have shrunk the deficit considerably, and the call on the company’s cash could be significantly reduced.

3. Companies with lots of debt

Companies with high levels of sterling-denominated borrowing market may find the cost of servicing new debt rising if interest rates start to shift upwards, which will depress reported profits.

4. ‘Bond proxies’

Dependable companies like Unilever and Reckitt Benckiser, and utilities like National Grid, have been dubbed ‘bond proxies’, because in a world where government bonds yield so little, investors have turned to these solid companies to provide them with a reliable income without too much risk. If bond yields rise, this trend could reverse. However because yields are likely to rise slowly, this isn’t likely to happen overnight. In the meantime these companies have time to grow their profits which should help to underpin their share price, if their track record of providing consistent earnings growth continues.

5. Housebuilders

A rise in interest rates is negative per se for the UK housebuilders like Taylor Wimpey and Barratt Developments, because it increases mortgage costs. However rises are likely to be small and affordable, and while they may constrain house price growth to some extent, demand will still significantly outstrip supply, which will support prices.

Furthermore the fortunes of the housebuilding companies appear to have become somewhat decoupled from those of the wider housing market. The recent weakness in house prices shown by the likes of the Halifax and Nationwide housing trackers seems to have been at the top end of the market. With the exception of Berkeley Group that’s not somewhere the big housebuilders operate. The other big players all have average selling prices somewhere in the region of £200,000-£275,000.

Secondly, new builds continue to receive substantial support from the government in the form of Help to Buy. This probably explains why average sales prices continue to climb across all the major housebuilders, even when the wider housing market has struggled.

6. Retailers

An interest rate rise is a double edged sword for retailers like Next and M&S. If it prompts a significant rise in sterling this will help defray the rising cost of imported goods that has stemmed from the post-Brexit depreciation of the currency. However it will also divert more money from consumer purses into mortgage payments, leaving them less willing to spend on discretionary items.


You’re about to read press releases, which we’ve written for media use only. They’re not intended for individual investors. They’re not personal advice and don’t include any recommendations.