Impact of rising interest rates on funds, markets and investors
Equity investors – equities won’t take kindly to an interest rate hike in and of itself, but rising interest rates are a sign the economy is in more robust health, and that should be good for corporate earnings. The worst case scenario for equity markets is stagflation, where interest rates rise simply to fend off inflation, but the underlying economy is going sideways, making it harder for companies to grow their sales. Equities are a better place to be than bonds in a tightening cycle however, and at least offer protection from inflation over the long term, which should help to underpin share prices.
Indebted companies – a rate hike would increase the interest bill paid by companies on their borrowings, so those with largest debt piles would find their earnings worst hit. Pension contributions for legacy finance salary schemes could also rise, as these are linked to bond yields. These effects would likely take some time to feed through, as pension funding is reviewed only once every three years, and corporate debt refinancing at higher rates will also take place gradually over a number of years as cheaper, older debt matures, to be replaced with more expensive borrowing.
Tech and growth stocks – more immediately, stock valuations might get clipped back by a rise in the risk-free rate – determined by government bond yields, especially in the US. Those companies with valuations based on more distant earnings streams, like some tech companies, would find themselves at the sharp end of proceedings, and in fact we already have seen the US tech sector sell off in the last month or so, as US bond yields have risen.
‘Bond proxies’ – would also likely see share prices come under pressure, as investors are tempted out of companies like Unilever, Johnson & Johnson and the utilities sector, and back into their natural habitat of bonds, as yields rise and therefore offer better relative returns. The share prices of these companies have done exceptionally well in a low interest rate environment, but they will find the going gets tougher if monetary policy tightens.
Banking sector – higher interest rates should be good for banks. The ultra-low interest rate environment has compressed the interest margin between deposits and loans, which are a bedrock of profits for commercial banks. Bad loans shouldn’t tick up too much, as any interest rate rises are going to be very gradual. The slow pace of tightening policy means bank profits aren’t going to skyrocket overnight, but shares may well appreciate as the market prices in a better monetary backdrop for the sector.
