Rising Interest Rates: The Positives and Negatives for Investors

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Last week saw a flurry of interest rate rates from central banks around the world.

On 4 May, the US Federal Reserve voted in favour of a 0.5% interest rate rise that will see its benchmark Federal Funds Rate move to a range of 0.75%-1%.

Meanwhile, in London, on 5 May the Bank of England shared the same sentiment.

Their Monetary Policy Committee voted for an increase in the Official Bank Rate by 0.25%, bringing the British benchmark to 1% from 0.75%.

Meeting minutes are not yet available to discover whether this vote was unanimous or a majority decision, but this marks the fourth successive uptick in UK rates in the last four meetings of the Committee, indicating that the members MPC remain on the same page.

Financial markets have seen volatile trading sessions as investors digest these events.

On Wednesday, the S&P 500 leapt by 3% in 24 hours on the news of the US decision.

On Thursday, the FTSE 100 index closed level with its opening value, having initially climbed to 1.5% by midday.

What is the outlook for stock market investors in light of these policy changes, and what can we expect from our equity portfolios over the coming year as a new economic reality of high inflation and rising interest rates takes effect?

This article will provide analysis from different viewpoints. 

The positive outlook:

Higher interest rates suggest a return to normality in many respects for financial markets.

Ever since the financial crisis in 2008-20211, a monetary curse was placed across developed economies.

Central banks slashed rates to historic lows in the wake of the financial crisis and the recession that followed, but in the ensuing recovery years, they found themselves in no position to lift rates without sending their economies into recession.

This fragile state of play saw rates sit at or near zero in many economies, such as the US, Canada and UK, and German rates even went negative.

This robbed central bankers of their key stimulus tool of lowering interest rates, because rates could be lowered no further.

Instead, they resorted to a new technique known as ‘quantitative easing’, which involved large scale asset purchases which otherwise helped support prices. 

The positive outlook of current raises (and many further anticipated rises to come) is that the Bank will now have significant room to lower interest rates as needed to stimulate the economy which should help the UK avoid a serious recession in the near future.

These recessions are usually a significant threat to investors who buy equities via stockbrokers such as DEGIRO, as equity markets suffer downward shocks when economic indicators fall.

UK investors with heavy exposure to foreign entities will also benefit from a devalued pound.

The UK’s economic forecasts were gloomier than those of the Fed, resulting in the British Pound falling to a two year low against the US Dollar on Thursday.

This will cause the GBP value of any investments denominated in a foreign currency to rise.

The negative outlook

On the pessimistic front, stagflation is becoming a reality. Stagflation is the combination of low (or negative) growth with high inflation, resulting in negative growth in real terms.

Stagflation is a rare phenomenon, most closely associated with the Japanese economy from 1990 onwards.

Stagflation can lead to a reduction of living standards and is, therefore, something that central bankers and the government will want to avoid at all costs.

Stagflation is unusual because the primary cause of inflation is usually an overheated economy.

By this, we mean an economy that is over-trading its natural capacity to produce goods and services.

When an economy is strained and stretched, labour shortages force wages upwards, and the price of goods also rises as consumers and businesses compete to secure the products they want.

However, this is tolerable in the context of a booming economy because both the workforce and the government experience rising incomes that can be used to pay higher prices.

In a stagflationary environment, products & services rise in price and fall in affordability.

The poorest suffer most as the price of staple foods and essential services become too expensive to buy and deprivation sets in.

The government finances become strained, because while tax receipts may rise in nominal terms (due to prices and wages being higher), the real spending power of those tax receipts will fall, meaning the Chancellor will find himself with fewer resources to re-distribute around the economy.