How rising interest rates can impact the stock market

Key Takeaways:

• 2022 has seen the most significant interest rate changes since the 2008/09 financial crisis.
• Growth stocks are likely to be the biggest losers in a higher rate environment, as the value of their future earnings decreases in today’s money.
• Some businesses and sectors can do well in a higher rate environment, a well-diversified portfolio is key to riding interest rate and economic cycles.

We started 2022 with the UK base interest rate at 0.25%. The Bank of England’s (BoE) most recent 0.5% rate rise takes the current base rate to 3.5%. This marks the most significant year for interest rates since the global financial crisis in 2008/09 and markets are expecting more hikes into 2023. Current estimates have the base rate somewhere near 4.5% by the end of next year.

BoE base rate

Source: Bank of England, 15/12/2022.

Generally speaking, interest rates and stocks tend to move in opposite directions. When rates rise, it should, in theory, make cash savings more attractive. If your savings at the bank are making a reasonable return, it becomes harder to justify the extra risks that come with investing. Plus, things like mortgages and credit card debt become more expensive, so people with debt have less to spend. This can have knock-on effects on company profits and ultimately returns.

Some sectors are more insulated than others and some companies are better prepared to cope.

This article isn’t personal advice, if you’re not sure whether an investment is right for you, seek advice. All investments and any income they produce can fall as well as rise in value, so you could make a loss. Ratios and figures shouldn’t be looked at in isolation, it’s important to consider the bigger picture.

The value of growth will decline

One way to value stocks is to look at the cash investors expect them to generate in the future, and discount those values back to the present day.

When you buy a share, you’re paying now for money you hope to receive later. Presumably, you’re expecting to get more than you’ve put in – though that’s never guaranteed. How much more depends on the discount you receive for paying now, alongside the many other factors that go into business performance.

Assuming everything else is constant, £100 in ten years is worth £70.89 today if interest rates are 3.5%.

£100 in ten years would be worth £64.39 if rates rise to 4.5%. When rates are low, future cash flows are worth more today. As rates rise, those future flows start to be worth less in today’s world.

This impacts growth companies more than others because investors are willing to pay a lot today for slim near-term profits, or even losses, on the assumption that earnings will come further into the future. That’s why the price-to-earnings (PE) ratio, looking say just one year ahead, tends to be higher. If rates rise, the value of those future cash flows decreases. All else being equal, that’s bad news for growth companies.

Interest rate and economic cycles are part and parcel of investing. It’s important to keep a level head and remember time is your greatest asset. Quality companies, be they growth or value, tend to come out the other side intact.

Banks can benefit

While the wider market tends to react negatively to rate increases, there are some sectors that will be cheering the hike. Banks are one of them.

The past decade’s low-rate environment has been tough on banks. The BoE’s base rate effectively caps how much they’re able to earn when they loan out money.

Banks make a profit by charging a higher rate on loans than they pay on deposits. As rates rise, the difference between the two grows, and so do net interest profits.

The impact won’t be equal across the board. Banks that depend heavily on lending will see a larger benefit than those that are more diversified with alternate income streams, like trading platforms.

This is a double-sided coin for banks, though, who’ve have had to set aside millions of pounds in preparation for higher loan defaults next year. That’s a direct result of higher interest rates, a cost-of-living crisis, and the recession we’re expecting to come. The good news is that these can be unwound if conditions aren’t as bad as feared, though there’s no guarantee.

Demand for borrowing will fall

On the contrary, rising rates are bad for anyone who needs to borrow money, because the rate you’ll pay is higher – like with mortgages, loans, and credit cards. When the cost of borrowing rises, demand for loans has tended to drop off. It’s a trend we’ve seen in the past and something that’s starting to creep into the current market in areas like mortgages and loans to small businesses.

For sectors like the housebuilders, that’s bad news. But there are some tailwinds that’d ease the pain. UK housing supply has fallen well short of government aims for several years. It’s picking up, but there’s plenty of room to grow if we’re to hit the 300,000 new homes a year target.

Housebuilders with strong balance sheets and those that generate a larger proportion of revenue from partnerships with local councils working to address the housing shortage could be more insulated.

This is something you can find out by reading a company’s annual report. Our Share Research team keeps an eye on this kind of data for a range of housebuilders, as well as 100+ of the most popular shares on the market. Sign up for share insights to have company updates and more sent straight to your inbox.

The cost of debt will rise

Those buying new houses aren’t the only ones who’ll suffer as rates rise. Borrowing will become more expensive for businesses as well. Low rates over the past decade’s made the decision to take on new loans much easier.

This isn’t necessarily a problem. While the BoE estimates an increase in businesses facing debt repayment challenges, it thinks rates will have to rise at a much higher pace to cause significant issues.

Nevertheless, on an individual company basis, there are some situations where it can become a burden. Just like a mortgage, corporate debt can be fixed or variable – meaning the interest rate is agreed to stay fixed over a period, or it can change alongside the base rate.

If the debt is variable, rising rates can be an issue, as the repayments become more expensive. Some variable-rate debt won’t break the bank, but a company that has a large proportion of variable-rate debt will be more exposed to rising rates.

Fixed-rate debt doesn’t necessarily guarantee an easy ride either. At some point, that debt will mature, and the company will either have to pay it back or refinance.

When debt matures, companies will have to make a choice – pay it back or swallow increased finance costs. A 0.25% or 0.5% increase doesn’t sound like a lot, but when you’re talking about multi-million-pound loans, it starts to add up.

To figure out whose debt has the potential to become dangerous, it takes some legwork, but it can all be found in a company’s annual report and accounts.

As with most metrics, it’s best to compare between two similar businesses within the same industry. It’s not the only factor to consider when making investment decisions, but could help you decide between two very similar companies.

The bottom line

It pays to keep an eye on economic trends and use them when it comes to making investment decisions. But investors shouldn’t be rushing to make changes off the back of another rate hike.

The key to a successful investment strategy is time and diversification. Even if rumblings about interest rates spook the market, a long investment horizon and well diversified portfolio means volatility is more likely to be a blip on the radar.

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