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How rising interest rates can impact the stock market

We look at ways the Bank of England’s interest rate hike could move markets.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

It’s been almost 15 years since the Bank of England’s (BoE) meaningfully increased interest rates. They’ve been below 1% for over a decade. So, jitters about the Bank of England’s decision to bring rates up to 1% are to be expected.

BoE base rate

Source: Bank of England, as of 06/05/2022.

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 have less to spend. This can have knock-on effects on company profits and ultimately returns.

But before you consider if you need to take any action, if at all, there are a few things to consider.

First, the scenario above typically applies to an interest rate environment that’s ahead of where we are right now. The bank’s most recent hike brought rates to 1%. Mortgages are still relatively ‘cheap’, and banks have been reluctant to pass the bump on to savers so far.

More importantly, the long-term case for investing stands – even as rates rise.

From 4 August 2016 to 2 August 2018, the BoE increased interest rates from 0.25% to 0.75%. During that time, the FTSE 350 rose roughly 22%. Although past performance is not a guide to the future.

FTSE 350 Performance

Past performance is not a guide to the future. Source: Refinitiv, 06/05/2022.

The latest rate was the third so far this year and markets don’t think we’ve seen the last. With that in mind, it’s worth considering how a rising rate environment might impact your investments.

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

The value of growth will decline

All stocks are priced according to the cash investors expect them to generate at some point in the future.

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 and the future prospects and demand. A lot can change.

Assuming everything else is constant, £100 in ten years is worth £90.53 today if interest rates are 1%. The discount in this case is minimal, just a quarter of a percent.

£100 in ten years would be worth £88.32 today if rates rise to 1.25%. 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.

Growth companies tend to have higher price to earnings (PE) ratios than their peers. Investors are willing to pay a lot today for slim profits, or even losses, on the assumption that earnings will come in the future. If rates rise, the value of those future cash flows decreases. All else being equal, that’s bad news for growth companies.

If the rate hike is gradual, it’s fair to assume growth stocks will see a period of stagnation while valuations catch up to the underlying fundamentals. But a short, sharp increase could usher in a period of more market volatility as value stocks with a higher portion of near-term cash flows gain favour.

In this scenario 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.

This article is not personal advice, if you’re unsure 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.

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 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.

Geography makes a difference as well. While rates are quickly on the rise in the UK and the US, the Eurozone has expressed a desire to take a more gradual approach. Banks with a larger exposure to these areas might not benefit as much as those who count the UK as their largest market.

Mortgage costs will rise

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 – as we’ve seen for mortgages in the past.

We’re not quite there yet, lenders reported a slight increase in demand over the first quarter and expect that to continue into the second. There’s likely a limit though, and if mortgage costs keep rising the housing market could start to cool.

That wouldn’t be ideal for housebuilders, 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.

Total new build completions in England

Source: Department for Levelling Up, Housing and Communities, March 2022

If we do reach a level where mortgage costs start to hurt demand, 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.

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The cost of debt will rise

Those buying new houses aren’t the only ones who will 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. And we’ve seen an increase in corporate debt as a result.

UK corporate debt as a % of GDP

Source: IMF, 2020.

This isn’t necessarily a problem, but 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 changing rates. If the BoE continues to push rates higher this year, it could mean a sharp increase in finance costs.

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.

Part of the reason corporate debt has risen so quickly in the past is it made sense to refinance at a lower rate. When debt was due, companies took on another loan, which often lowered repayment costs.

If rates rise, this won’t be the case anymore. 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

The key to a successful investment strategy is time. Even if rumblings about interest rates spook the market, a long investment horizon means volatility will be but a blip on the radar.

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 on the prospect of another rate hike.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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