Despite voting 7-2 to maintain the base rate at 0.25% during its September 2017 meeting, the Monetary Policy Committee, as expected, raised interest rates from 0.25% to 0.5% during its October 2017 meeting.
The dichotomy between weak growth and elevated inflation provided a dilemma for policy makers at the Bank of England – whether to raise interest rates in order to bring inflation down towards its 2% target, or to maintain its former accommodative stance to help stimulate growth. The UK economy grew 0.4% during the third quarter of 2017, following growth of 0.3% during the second and 0.2% during the first, considerably slower than the upgraded Q4 2016 figure of 0.7%.
The case for an interest rate rise was very much premised on the assumption that the output gap, which represents the difference between current output and potential output, is now smaller, with spare capacity within the economy being absorbed quicker than anticipated.
An unemployment level of 4.3% in the three months leading up to July 2017 has been suggested as evidence of this with some economists believing that this level is at, or indeed below, the natural equilibrium level of full employment.
Inflation remains heightened; CPI rose to 3.0% during September 2017, well above its target of 2.0% and just below the level at which the Governor of the Bank of England has to write an open letter to the Chancellor explaining why the level has deviated from its target.
This is likely to remain elevated going forward; the Bank of England, as set out in the August 2017 Inflation Report, has forecast that CPI will remain above the 2% target up to mid-2020, as currency-induced cost pressures continue to exert their influence on the price level. Indeed, the recently released November reading saw CPI rise to 3.1%.
What will the interest rate rise mean for investors?
For some asset classes, movements in interest rates have direct effects; in others the implications are a lot less explicit.
In an environment where interest rates are rising, we can expect the prices of fixed income securities to decline; there is a direct inverse relationship between interest rates and prices.
In such an environment, newly issued bonds will offer investors a higher return than those currently trading on the secondary market. As such, the prices for these outstanding bonds will decline as the demand becomes depressed when investors naturally veer towards the securities offering a higher return. In addition, those bonds with longer maturities, like those to which pension schemes are often highly exposed, are more vulnerable to changes in interest rates and so price changes are amplified.
Increased borrowing costs are also likely to have a negative impact on mortgages, with interest expenses increasing for those on variable and base rate tracker contracts. This is likely to have a knock-on effect on the wider property market as expensive mortgages will depress house prices due to lower demand.
The effect on equities isn’t quite as predictable. Conventional wisdom tells us that interest rate rises are negative for equities; the increase in the base rate will be mirrored by the high street banks, pushing up the cost of borrowing on credit cards and other form of debt. The added cost of interest payments would have a negative effect on disposable income, thus leading to a contraction in consumer spending. The repercussions of this would be tighter margins for companies and cuts to cash flows which ultimately make their equity less attractive for investors. Increased borrowing costs will also directly affect margins as debt servicing costs increase.
The interest rate charged on government bonds should also be considered. Above all viewed as the safest of investments, bonds are often used as a proxy for the risk-free rate – the theoretical return on an investment with zero risk, and representing the minimum return an investor would expect from an investment in any asset. The risk-free rate is of fundamental importance in financial theory, being used as the main component when calculating the discount rate, the rate by which future cash flows and dividends are discounted when calculating present values. The increase in the interest rate, therefore, will push up the discount rate, depressing the values of future cash flows, and therefore demand for these securities.
Conversely, rising interest rates are often indicative of a strengthening economy; as the economy grows and the population becomes wealthier, consumer spending increases. This boosts cash flows resulting in higher profits and higher earnings, which makes the stock more attractive for investors. However, as we have seen, the economy is currently experiencing a soft patch. The implications of the interest rate rise are therefore likely to be negative for equities, with investors potentially using this as an excuse to take profits.
Overall, the modest 0.25% increase in the interest rate rise has only reversed the interest rate cut made following the 2016 EU referendum. This is unlikely to have a material effect on investments.
Matthew Tucker, Investment Analyst at Quantum
matthew.tucker@quantumadvisory.co.uk