What impact do rising interest rates have on equities?

It cannot have escaped your attention that the UK, like much of the rest of the world, is suffering from high inflation at the moment. UK CPI hit a new 40 year high of 10.1% during July and has stayed stubbornly high since then. The weak pound is not helping matters as it means any goods and services that are imported to the UK are more expensive, pushing inflation further to the upside.

To attempt to bring down inflation, Central Banks around the world have been increasing their key interest rates. The Bank of England recently increased its base rate to 3%, with the latest hike of 0.75% representing the largest since 1989. This leaves the rate at its highest level for over 14 years. By comparison the rate was only 0.25% at the start of the year. Market expectations of where the rate will end 2022 are changing by the day, but it is expected that the BoE will announce a further hike in December.

The theory is that higher rates will cause consumers and business to reduce spending and investment. Apart from causing demand to fall, there is also an argument that higher interest rates should cause prices of equities to fall, as it means their future earnings and cash flows should be discounted at a higher rate, meaning they are worth less today.

We decided to put this to the test, to see whether rising interest rates do indeed cause equities to struggle.

As you can see from the chart below of UK base rate since 1970, the rate has been in a secular decline for the past thirty years. However, we do have periods, particularly in the 1970’s, when rates were increased meaningfully.

There are a total of 20 years where the base rate rose over the course of the year. Over these years we see that the FTSE All Share Index (ignoring dividends received[1]) rose on average 6.2%. This is materially lower than the average 9.1% gain for the Index over the full fifty years.

The fact that the FTSE All Share has already fallen 10.6% during the first three quarters of 2022 (again ignoring dividends received) gives us some confidence that the worst of the impact from rising rates may already be behind us. Also, the expectation of further rate rises this year should already be factored into current equity prices.

However, what we are really interested in is how equities go on to perform in subsequent years. On this front, the news is even more promising. We can see that in the five years following a year in which the UK base rate rose, the All Share Index enjoyed an average gain of 58.8%. This is not noticeably different from the average 5-year return of 59.8% following years when base rate fell.

Source: Financial Express Analytics

Moreover, if we focus on the six occasions when the UK base rate rose by more than 2% during the year (which will almost certainly be the case in 2022), the All Share rose on average by 83.1%.

The conclusion appears to be that equities do seem to react negatively to base rate hikes in the near term, as has occurred this year. However, the future returns over the medium term do not seem to be particularly affected, and we have some evidence that for years that rates have been hiked significantly, the subsequent returns are better than average.

[1] We have excluded dividends as we only have dividend data for FTSE All Share from 1986.

Mike Evans – Head of Portfolio Management