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How do interest rates impact the stock market?

A closer look at one of the factors in share prices

Topic: Investing

If you’ve read our round-up of what’s been affecting your investments in 2018, you’ll notice that interest rate rises have been a theme of the year.

It might not be immediately clear why the rate of borrowing and lending has such an impact on share prices, so let’s take a look at the issue is a little more detail.

The essentials of interest rates

When money is lent and borrowed, the lender is incentivised to provide money because the borrower typically pays back more. How much more the borrower pays (and the lender receives) is determined by the interest rate. High interest rates are bad for borrowers, as they pay more - but good for lenders.

Many people are actually both borrowers and lenders – for example, if you’re a current account holder with a mortgage, or a credit card. But you probably borrow and lend in different proportions.

As mortgages are typically people’s biggest debts, this is where you’ll notice interest rate changes the most. People with tracker or variable mortgages will have higher payments when interest rates rise, and lower payments when they fall.

Why interest rate rises happen

Interest rates are determined by the central banks – for example, the Bank of England in the UK, or the Federal Reserve in the US.

Rate changes are driven by supply and demand. When many people are looking for loans, interest rates will increase. When there’s low demand, for example, in a housing market crash when fewer people are looking for loans, interest rates fall to encourage more borrowing.

Interest rates have a strong correlation with inflation. During periods of high inflation, borrowing increases, leading to interest rate rises following soon after. This explains why interest rate rises have been common recently.

The domino effect of interest rate rises

As we’ve mentioned, when interest rates rise, many peoples’ mortgage payments increase. And of course, when people are spending more on their mortgages, they’re not spending it elsewhere, so there’s less money going into the UK economy. Credit card borrowing costs go up too, adding to the pressure to spend less.

Even for those without debts, higher interest rates reduce the incentive to spend. People might be more inclined to put their money into savings accounts, as they’ll get a slightly higher return than before. This can be a mistake, as it ignores the relationship of interest rates and inflation. Because inflation is usually higher than interest rates, it could erode the value of your savings over time.

Having seen the impact of previous interest rate rises time and again, investors are understandably wary of them. Less consumer spending is bad news for most companies, and if businesses aren’t performing well their share prices will go down. Investors try to get ahead of this threat by selling off shares as soon as an increase is announced.

Interest rate rises in 2018

The threat of interest rate rises has loomed over 2018, because the year started on such a strong note. With strong global economic growth through 2017, all eyes were on the central banks, to see whether they would increase interest rates to combat inflation.

In the UK, rates were expected to rise in April. However, due to lowered growth expectations, the Bank of England maintained the rate of 0.5%*.

But the expected increase came instead in August, and at 0.75%* it’s currently the highest we’ve seen since the financial crash in 2008 (though previously rates of even 5% where common). It’s thought to be rising again in 2019, though any change will likely be led by the outcomes of Brexit.

The Federal Reserve has a policy of gradually raising interest rates in the US, which has led to eight increases since 2018 (it’s currently at 2.25%)*.

These rises, and comments in relation to them, have caused large stock market fluctuations in recent months, whether it’s Trump criticising them as ‘crazy’, or Federal Reserve Chair Jerome Powell’s famous phrase, ‘just below’, which we’ve examined in detail in our post US stock market: two words, big impact.

How we monitor interest rates

You can probably see that stock markets and interest rates are intrinsically linked. So, our 20+ strong research team is committed to monitoring the probability of increases in the markets that we invest in, so we can stay ahead of the inevitable market movement that follows.

That’s one of the benefits of having an actively managed portfolio, rather than investing in tracker funds, which will inevitably fall when hit by an interest rate rise.

*Source: Investec Wealth & Investment

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