Following a decade without so much as a hint of a rate rise, expectations are high for the UK’s second increase in just seven months.
Most economists expect the Bank of England to raise the base rate to 0.75 per cent this month, up from the current 0.5 per cent. The UK’s economic picture is now looking fairly rosy, with unemployment at a record low and wage growth nudging higher than inflation.
Caroline Simmons from UBS Wealth Management also points out that the recent outlines of a Brexit transition deal have softened business uncertainty, which means conditions look ripe for an interest rate hike.
But what impact could this have on the stock market?
“Even in the disingenuously orderly world portrayed by finance textbooks, the relationship between interest rates and stock prices is complicated,” says Will Hobbs, head of investment strategy at Barclays Wealth.
“If the quoted share price of a company is the sum of all of its predicted future cash flows discounted back to a present value (accounting for opportunity, costs, and other factors), higher interest rates should cut that present value. However, interest rates tend to rise when the economy is warming up, alongside corporate profits, which usually provides an important offset.”
So, how you can position yourself to benefit?
Higher interest rates make it more expensive for businesses to borrow, which means you should be looking for firms with strong balance sheets – that is, companies with healthy profits, and no or low debt.
You should also focus on sectors with most to gain from the gusto of a growing economy, and banks are an obvious starting point, says Hobbs, noting that higher interest rates tend to boost the banking sector’s profitability.
Businesses that hold significant amounts of client money should profit from a rise in interest rates
Insurance companies could be another safe bet.
“Insurers should also be able to generate higher profits from re-investing their premiums in higher yielding bonds,” says IG’s Oliver Smith.
UK banks have reformed since the credit crunch of 2008, making them far more appealing from an investment perspective.
“Many financial services businesses that hold significant amounts of client money should profit from a rise in interest rates from what is an exceptionally low base,” says Lee Wild from Interactive Investor. He points out, however, that it’s unlikely this will translate into better returns on cash savings this time around, with businesses more likely to pass the benefits onto their bottom line.
Where to watch out
And where are the danger zones?
With the peak of the house price boom behind us, Wild warns investors to be wary of housebuilders, which have become more vulnerable to a downturn in the cycle, particularly as increased borrowing costs put pressure on household budgets. “Rising mortgage costs could pop the housing bubble,” he adds.
You should also be wary of defensively-orientated stocks, particularly those with bond-like cash flows and dividend payouts, says Hobbs. He suggests that consumer staples and utilities are the two sectors which stick out.
Importantly, a rate hike could certainly serve as another blow to the retail sector, which has been battling various headwinds for years.
“Unfortunately, there will be little respite for the hard-pressed retail sector, which faces the triple whammy of rising borrowing costs, tightening consumer finances, and more competition from online competitors,” says Smith.
But the IG portfolio manager also points out that, while a rate rise was a dead cert just a couple of weeks ago, Friday’s disappointing GDP data has dampened some of the excitement, meaning markets now attribute just a 28 per cent probability of an increase.
“Yet,” he adds, “this actually presents more of an opportunity for stock pickers; if there is a rise in rates it should create some share price volatility, with expectations that the economy is healthier than it looks.”
There’s certainly no doubt that Mark Carney’s comments will be closely analysed by the market. It’s interesting times all round.
Source: City A.M.