Budget bonanza – it was only last week that the Chancellor announced a huge spending splurge, and the Bank of England would be wise to take some time to properly consider what effect this may have on price rises. Overall the Treasury’s spending plans look inflationary, particularly when combined with a rise in the National Living Wage. There are deflationary elements to the fiscal plan laid out in the last two Budget’s however, in particular the freezing of tax thresholds and the rise in corporation tax will restrain consumer and business spending, and the allocation of some of the Chancellor’s economic windfall to paying down debt. Given the short turnaround between the Budget last week and this Thursday’s MPC meeting it seems unlikely the committee will as yet have had sufficient time to analyse the impact of the Chancellor’s policies.
Asymmetric firepower – the Bank of England has plenty of firepower to deal with inflation. Rates are so low it has huge scope to tighten policy, but it has almost no room for manoeuvre in the opposite direction. That is one good reason that in the longer term rates should rise, so that the Bank can once again stimulate the economy if needed. The tricky balancing act for the Bank is to rebuild that firepower without tipping the economy into a state where it needs to be stimulated.
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, could find themselves at the sharp end of proceedings.
