Interest rates and the UK stock market

Early in January, the Bank of England caught the market by surprise by raising interest rates by 0.25% to 5.25%.

According to Abbey’s John Kelly, “In reality this was only a surprise in terms of timing, coming as it did in advance of the quarterly inflation report. It was always likely that the Bank would have to move rates higher fairly soon in the new year in response to the pick-up in core inflation seen over recent months.

“Until recently higher input costs had not been substantially absorbed,” continues Kelly. “This was either because strong margins had allowed the pursuit of volume or, typically on the high street, consumer resistance had just been too strong. This phase seems to be coming to an end as the extended upswing in economic activity closes the output gap. Money growth is strong and housing – the source of so much consumer spending – is resilient.

“Wages are also becoming an issue. Unemployment is currently 5.5%, as steady growth in jobs at about 1% is balanced by growth in the labour force from immigration and older workers retuning to employment. It is far from certain, however, that this compensatory growth in numbers will continue to offset rising demand for manpower. Real wage growth has fallen from about 4% at the end of 2001 to around 1% now and with significant hits to disposable income from fuel and travel costs – amongst many – there is a risk of upward pressure on pay settlements. In this regard, the pick-up in inflation is of particularly unfortunate timing. Headline RPI of 4.4% is hardly the statistic of choice for a Chancellor trying to keep public sector increases to just 2%.

“Of course, trends in the domestic economy have to be considered against the background of international developments. There has been much talk of a ‘soft landing’ to the world economic cycle but so far there has been precious little sign of it. In Europe, activity is rising and in the United States, as attested by the fall in the number of new jobless claimants and the surprising strength in new housing starts, momentum is still strong.

“How threatening is this to investors? The answer is not threatening at all. What we seem to have unfolding in the UK and elsewhere is a reasonably standard late cycle scenario. Prolonged economic growth has created nascent inflationary pressures and a few hot spots that central banks are trying to cool. There are no signs of the excess which in the past has caused authorities to bring the upswing to a crunching stop, now the intention is slowdown activity in certain areas but to leave overall momentum intact.

“Continued growth will see further rises in company earnings. Over the past four years, the domestic equity market indices and forecasts of future earnings growth have moved pretty much together and while expectations of multiple expansion are optimistic, there is little justification for contraction either. What strategy should investors adopt in this scenario? In particular, is it now the time to be wary of interest rate sensitive stocks? The answer is no – it is far too late for that. For example, the bank sector, one clearly exposed to interest rates and the impact of higher borrowing costs on consumers, reached a relative performance peak in 2002/ 2003 and since then has lost ground against the rest of the market. A more credible approach is to look ahead, not to the next rise in rates but to what comes after that, to the timing and circumstances behind the fall in rates that we expect to begin in the second half of this year.

“For bonds, interest rate trends will become a secondary influence on prices as liquidity issues move to the fore. We expect current excess levels of easy money to reduce keeping yields higher for longer.

“In equity markets, moderating domestic growth will become a key driver to relative returns. Larger companies with good growth will become a key driver to relative returns. Those with good growth characteristics and an international exposure should do particularly well.”