What to expect from stock prices as interest rates rise

For almost 15 years, interest rates in the UK have barely moved. It has been more than ten years since the base interest rate was more than 1%. Yet, UK interest rates rose by 0.25% points to 0.75% in March 2022, and another rise is likely when the banks’ Monetary Policy Committee meets again on May 5, 2022.

The base interest rate set by the Bank of England determines the price of borrowing for all individuals and businesses in the country. This is because it is the price at which all banks must fund their business.

With interest rising for the foreseeable future, many people wonder how interest rates affect stock markets.

Interest rates and inflation

The Bank of England, like most others, controls inflation by moving interest rates. They must balance inflation with healthy economic growth and low unemployment. The bank’s inflation target is less than 2%. Inflation has been rising rapidly over the past few months. It reached a 30-year high of 6.2% in February, and has affected the consumer confidence and sales. There is pressure on the bank to get inflation under control.

For central banks, the interest rate is the most potent instrument for controlling inflation and economic growth. Interest rates have been very low for some time now. Low-interest rates encourage businesses and individuals to spend and invest their money. The increased spending encourages economic growth, but it can also lead to inflation when suppliers battle to keep up with demand.

When interest rises, organizations and individuals prefer to keep their money in the bank, and so they spend less. This puts the brakes on economic growth and can help prices to stabilize.

How does interest affect stock prices?

Rising interest rates don’t have a direct effect on stock prices. In theory, a drop in interest rates should cause share prices to decrease. Still, economists argue that rate increases can have the opposite effect when the interest rates rise from a very low level as is the case right now.

Nonetheless, interest rate hikes have the following impacts on businesses and individuals

  • Operating costs rise
  • Consumers have less discretionary income
  • There is less incentive to invest in future development
  • Consumers prefer not to borrow money

So how does this affect the stock market? The cost of borrowing rises. For those with debt interest costs rise. This increases the cost of doing business and reduces profitability.

With less profit, there is less money to grow the business. Business owners also prefer not to borrow money at high-interest rates, so there is less money to invest in the future.

The reduction in profit and growth prospects will have a negative effect on the price of shares in the company.

Rising interest rates also affect consumers. Since they have less disposable income, they will have to spend a bigger portion of that income on necessities. They will thus have less money to spend on the big-ticket items.

The result is a reduction in consumer spending, demand, and sales. The reduction in demand translates into reduced profits for organizations. With less profit, they will invest less and their share prices may drop.

Some stock prices may increase when interest rates rise

All things being equal, in a robust and growing economy, interest rate increases won’t significantly impact the demand for products and services. If this is the case, stock prices may be unaffected. A company’s stock price reflects how investors view the business and its ability to earn a good profit in the future.

A rise in interest rates also won’t have an equal effect on all stock prices. Interest rate movements will have the biggest impact on growth stocks, like tech. Companies in growth industries have relatively high debt levels and anticipate profits at a much later date. Stocks in banks tend to do well when interest rates rise as they earn more on the spread between what they earn and what they pay in interest.

Insurance companies also do very well in a rising interest rate market due to holding long-term bonds. For investors, as always, there is safety in diversification. At this stage, you may be looking at changing your portfolio to accommodate the shifting circumstances.

 

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EWN

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