What Happens When UK Base Rates Rise? After leading us to believe that any rate rise would be next year in recent days Mark Carney Bank of England governor is now indicating that the first base rate rise will be this year. This could be to avoid making changes near to an election. Historically there appears to be an unwritten rule in that rate changes will be at least 6 months either side of an election and in America this is a written rule. This is to avoid any benefit or detriment to any political party. Yet again today he has moved to cool speculation he will trigger a base interest rate rise sooner rather than later. He stressed that the timing of any rate rise is not as important as the fact any increase in the base rate will be limited and gradual. Economic impact: previous experience From the early 1970s to the early 1990s, UK interest rate increases, which were typically engineered in order to curb excessively high inflation, often led to a slowing of economic growth typically sharp enough such that a recession eventually ensued. Since then, however, rate increases have not led to such a slowing and recession. In the 1990s and 2000s interest rate tightening phases were accompanied by relatively firm growth and contained inflation. The economy was – not too hot, not too cold, just about right. At the time, the general view was that careful calibration of the central bank interest rate could maintain the inflation rate in target and growth on a stable path. For a while, that was indeed the case. Economic impact: what now? In these circumstances – when some of the previous relationships between policy tightening and the economy have broken down – there are two key inter-related linkages between interest rate increases and the economy which we think will be of particular importance. First, and most directly, is the impact which higher interest rates have on consumers. • Interest payments as a share of household disposable income are expected to change as interest rates increase. Even with a rise of 200 basis points, interest payments would still account for less than the 8.5% average of disposable income seen since 1988. • Of course, not all households in the UK have mortgages. Out of the almost 25m households in the UK only 37% (just over 9m) have property debt. • Furthermore, households that have suffered as a result of low interest rates on savings would benefit from higher rates. Second, and more difficult to gauge, is the impact on consumer confidence. • Generally, in the past, consumer confidence in the UK has been boosted by lower rates. More recently, however, confidence has been improving even as interest rates have remained stable. Thirdly is the impact on currency, making sterling more attractive, imports cheaper and exports more expensive and thus a reduction in demand for UK goods abroad. Market impact: around the first rate hike Historically, we find that in the 6 and 12 months after the first rate hike, the equity market tends to de-rate (fall), with a lower price/earnings (P/E) ratio, but this is offset by increased earnings (dividends). Both before and after the first rate hike small cap stocks have produced the best performance, followed by mid cap then large cap stocks. The house building sector is typically the best performing sector in the 12 months before the first rate increase; and the worst performing sector afterwards. Utilities have tended to be the worst performing sector in the 12 months before the first rate rise; and have been the second worst performing sector afterwards. Gilt yields have generally fallen once base rates have started to rise. The rise in gilt yields in 2013 may be an indication that a similar pattern is being seen in current circumstances. Corporate bonds are more difficult to predict; In the late 1990s both corporate bond yields and the spreads over gilts rose before the first rate hike; in the 2000s yields fell both 12months pre and post the first rate hike. Market impact: full cycle The performance of UK equities, gilts, house prices and sterling corporate bonds from the first interest rate increase to the first rate cut- The important points are that: • in all cycles there were positive returns across all asset classes. Timing is key. • on average equities outperformed gilts • both those asset classes performed better than house prices. Across the entire market cap range, interest rate tightening cycles have generally seen a market de-rating (fall)- with a lower P/E multiple, offset by improved earnings (dividends). Unfortunately we cannot predict the future and historical patterns may not be repeated! For details on the wider economy and other factors impacted by a base rate rise please visit petehart-ifa.co.uk
Posted on: Tue, 24 Jun 2014 14:00:00 +0000