Smaller companies – in theory, smaller companies are more fragile than their blue chip cousins, as they have less robust earnings streams and access to capital. In some cases, higher interest rates would increase their debt burden, and could push them further towards the cliff edge of losses and insolvency. Their stock prices are often predicated on longer term growth too, and so higher interest rates and inflation could mean we see some valuations pegged back. That’s particularly the case seeing as the UK’s small cap index has been hitting record highs of late – the FTSE Small Cap is up 43% in the last year, compared to 23% for the FTSE 100 (source: AJ Bell, FE, total return to 12th October 2021). However, not all smaller companies carry significant levels of debt. And while smaller companies aren’t immune from what’s going on in the wider economy, the drivers of growth are more secular and idiosyncratic, which can bolster share prices even in troubled times. The long term performance of this section of the market has also been exceptionally strong, particularly when partnered with active fund management.
Residential property – higher mortgage rates should take some of the steam out of the housing market. Prices could fall, but a moderation of price growth seems more likely, given the ongoing imbalance between supply and demand, and the presence of continued government support in the form of Help to Buy and the Mortgage Guarantee scheme. The Bank of England certainly won’t want to put so much strain on the economy that homeowners are posting their keys through the letterbox as they leave, because they can’t afford mortgage payments.
Commercial property – commercial property prices could also come under pressure from interest rate rises, which heap pressure on tenants by increasing their debt bills. If the economy is in fine fettle though, that should mean businesses can afford the extra costs, though the good times may not be split fairly amongst all sectors. As an asset normally held for income, the commercial property sector may see outflows if bonds and cash start offering a more attractive yield. That could spell more trouble for the open-ended funds invested in commercial property, where large outflows might increase the risk of trading suspensions. The sector is already on tenterhooks waiting for the FCA to announce if notice periods will become mandatory, which could also prompt an exodus from the sector.
Taxpayers – rising interest rates would also be extremely negative for government finances, and by extension, the taxpayer. Government bond prices have already adjusted to the prospect for higher inflation and tighter policy, with the 10 year yield rising from 0.5% to 1.1% in just two months. In ‘normal’ conditions, rising rates only affect new government borrowing, but today, the QE programme has effectively pegged £875 billion of government debt to the base rate. This is a floating rate that can change interest payments overnight, unlike the fixed rates of the gilt market. In its Budget forecasts in March, the OBR estimated that if interest rates were 1% higher, that would add £20.8 billion to the government’s debt interest bill in 2025/26. To put that in some context, that would wipe out all the £8.2 billion gain the Treasury expects from freezing income tax allowances, as well as a sizeable chunk of the £17.2 billion projected to roll in from the rise in corporation tax.
Gilt investors – conventional UK government bonds are directly in the firing line if monetary policy tightens, either through interest rate rises or an unwinding of QE. Some UK gilt funds have already sustained double digit falls so far this year, and the average UK gilt fund has lost 8.8% (source: AJ Bell, FE, total return to 12/10/2021, Investment Association UK Gilt sector). While that’s probably not enough to make most equity investors blush, investors choose bonds because they’re seen as safe havens. But twelve years of ultra-loose monetary policy has driven gilt prices so high, they now carry an awful lot of valuation risk, and offer a desultory yield in return.
