Traditionally there is an inverse relationship between interest rates and stock market performance. As interest rates go higher, stock markets tend to go down and vice versa. However, there may not be an immediate change in stock market performance in light of an interest rate change. There are many factors to consider!
Stock markets are strongly linked with economic growth both domestically and internationally. If economies are growing, listed companies will likely attract more business and post improved profits. On the flip side, if economies are struggling, companies may find it challenging to expand, and profits may stagnate or even fall.
There are numerous ways the Bank of England can use interest rates to maintain a degree of control over the economy. For example, if the economy was overheating, the Bank of England may increase interest rates. Conversely, if the economy was struggling, they may look to reduce interest rates.
It is debatable as to the optimum economic growth rate, but a steady 2% to 3% a year is favoured by many. Within this economic growth rate, you will see some sectors perform better than others. So, how do interest rates affect the stock market?
A recent report by The Money Charity cast a fascinating light on consumer debt in the UK. As of October 2021:
- Consumer debt was a staggering £1,749.9 billion
- The average household debt in the UK was £62,965
- Unsecured debt per UK adult was £3,713
- Credit card debt per household stood at £2,085
- Average adult debt was £33,086, a staggering 108.3% of average annual earnings
Consumer spending is the fuel that fires the UK economy and is at the heart of underlying economic growth. As interest rates on personal loans, credit cards and mortgages tend to follow the trend of base rates, an increase or reduction can significantly impact consumer spending. Low interest rates can make borrowing more attractive and affordable to consumers. In contrast, high rates will limit the availability of consumer finance. To put this into perspective, how many people could afford their own homes without mortgage debt?
Buoyant consumer spending will help businesses grow, but reduced spending will impact turnover and profitability, potentially curtailing expansion plans.
Discretionary income is the amount of funds available after deducting taxes and living expenses from disposable income. In effect, this is the amount of money over which you have a greater degree of discretion.
If interest on loans, credit cards, and other borrowing is relatively high, this will reduce your discretionary income and curtail consumer spending. Consequently, if the interest rate is relatively low, this will increase your discretionary income, encouraging spending, which leads to economic growth.
The UK base rate was increased from 0.1% to 0.25% before Christmas. While a significant turning point in the interest rate trend, this has done little for savings rates. When you also consider inflation, standing at 5.4% in January 2022, this is not a favourable environment for savers. In effect, savers are earning little in the way of interest, and the real purchasing power of their funds is reducing as a consequence of inflation. So, how does this scenario impact stock markets?
Aside from a degree of certainty regarding savings, there is little incentive to hold funds on deposit at this moment in time. Consequently, the attractions of the stock market will, for many people, outweigh the safe haven of savings accounts. Obviously, the greater the inflow of funds into the stock market, the stronger the demand for shares and in theory, stock markets should move higher.
On the flip side, the higher savings rates, the less attractive stock market investments will become for many people. The ability to earn a relatively high-interest rate, risk-free, would compare favourably to the investment risk associated with stock markets.
Historically, the Bank of England has used base rates as a relatively blunt but effective tool to control inflation. Inflation is the rate at which the cost of goods and services increase month by month, year on year, thereby dictating the cost of living.
A low interest rate environment could encourage consumer borrowing, increased consumer spending and an unhealthy increase in the cost of goods and services. Consequently, a high-interest rate environment will limit consumer borrowing, curtailing consumer spending, thereby reducing demand for goods and services. The less demand for goods and services, the less upward pressure on prices. How does inflation impact companies listed on the stock market?
At the very minimum, employees should be looking to maintain their relative spending power regarding wages. This is where inflation, measured by the consumer price index, comes into play. The higher the rate of inflation, the higher the potential increase in wages to maintain equilibrium in spending power. This feeds into higher running costs for businesses and higher goods and service prices to maintain profitability. At some point, an increase in the cost of goods and services will reduce demand, thereby reducing profitability.
The Bank of England has a target inflation rate of 2%, which many see as manageable. Consequently, the current inflation rate of 5.4% is not sustainable for a prolonged period. It will eventually increase business costs and the cost of living, reducing discretionary spending.
Business sectors sensitive to interest rates
To a certain degree, every business sector is impacted by interest rates, which ultimately impact consumer spending. Some examples of these are below.
The consumer services sector is perhaps the most sensitive regarding the movement in interest rates. Consumer borrowing typically increases in a low interest rate environment, leading to higher discretionary spending. In a high interest rate environment, consumer borrowings become less affordable, leading to lower discretionary spending. The greater the demand for consumer services, the more upward pressure on prices, leading to greater profitability for stock market listed companies.
The situation with the banking sector is a little more complicated. On the one hand, increased interest rates can lead to improved margins on personal loans, credit cards, and other borrowing types. High interest rates will also encourage consumers to save, and the bank can use funds on deposit to finance their lending operations. On the other hand, however, higher interest rates will reduce demand for borrowing, ultimately impacting turnover and profitability. Confused?
Housebuilding is also another sector heavily dependent upon relatively low interest rates. Low interest rates tend to encourage lower mortgage rates, making mortgages more affordable and attractive. In addition, the relatively low cost of mortgages will improve the demand for new homes provided by the housebuilders. The greater the need for new homes, the higher the prices paid and the more profits for housebuilding companies. On the flip side, high interest rates reduce the availability and affordability of mortgage funding, thereby reducing demand for new homes.
Technology is a sector that is extremely sensitive to movements in interest rates. In essence, low interest rates will encourage borrowing to fund more speculative investment in technology start-ups. Conversely, higher interest rates may encourage some investors to take advantage of enhanced savings rates, offering a relative risk-free return. This is why technology investment tends to increase when interest rates are low and reduce when interest rates are high.
These are just a few sectors that fluctuating interest rates can significantly impact. Of course, there are pros and cons in some scenarios, but in essence, higher interest rates lead to higher costs of borrowing and lower levels of discretionary spending.
Growth prospects are the key
Growth prospects are the fuel that fires the interest of investors looking at ways to maximise their returns. As covered above, the level of interest rates will ultimately dictate consumer spending, economic growth, and individual company profitability. Consequently, short to medium-term economic growth prospects will influence the funds flowing into stock markets.
As we have seen recently, record low interest rates have encouraged business and consumer spending and discouraged saving. Due to the minimal savings rates, many of those with funds available have been looking elsewhere for improved returns. This has led to an inflow of funds into the stock market, with company growth prospects benefiting from this low interest rate environment.
It is vital to monitor interest rates
As we touched on above, with average UK household debt now standing at £62,965, fluctuations in interest rates will impact discretionary spending levels. Relatively low interest rates will encourage consumer borrowing, leading to increased spending and economic growth. Conversely, high interest rates will curtail consumer borrowing, impacting consumer spending and reducing economic growth.
Interest rates have been a very useful means of controlling economies in the past, relatively blunt but effective. While just one of many economic levers available to the Bank of England, and the UK government, interest rate movements remain very much in focus. The outlook for the UK economy is central to the short, medium and long-term performance of the UK stock market. Consequently, interest rates have a significant impact on stock market returns.