How do interest rates affect equities?

This is for those interested in investments and how interest rates affect equities. The “talk of the town” in mid-late 2017 has been the potential for interest rate rises in the USA, UK and the ceasing of quantitive easing in the Eurozone. We would like to try to explain Aisa’s investment consideration for such matters in a way that is of interest to you.

Do Interest rates affect equities?

interest rates affect equities
Let us first of all understand that when you print money (quantitive easing) you are putting more money into circulation which in turn, devalues the money already there. This oversupply during the last 10 years has been combined with low interest rates. Whilst banks have re-capitalised in the UK and the USA, they have also lent out more capital from this new money. In brutal terms, everyone who has been borrowing to invest, or who owns assets such as property, benefit due to asset price increases linked with all that new spare cash in circulation.

What eventually happens, however, is people with less money, no assets or high borrowings become susceptible to potential inflation as prices go up but their salaries do not due to low salary inflation, and / or potentially higher borrowing costs. In the UK we have seen the devaluation of sterling due to Brexit fears, leading to inflation. In this instance Brexit fears are a catalyst rather than a cause. However, people on lower salaries will need to seek wage increases or more borrowing or both!

Businesses and governments that pay the wages therefore have to make lower profits (have a higher deficit for a government) or they have to put their prices or taxes up. Clearly a business making lower profits would pay out lower dividends, so they put prices up or seek cost savings, often via redundancies. Ironically both of these impact on the very same people that are already struggling as companies seek efficiency and greater productivity.

Thus you enter a vicious cycle and the way a Central Bank, such as the FED or Bank of England, attempts to reduce the impact of this cycle is to increase interest rates and reduce cash in circulation (the polar opposite of what has been going on for the last 10 years). This has to be done very carefully, as any reduction in stimulus will naturally affect all assets. We do not see this happening in the next 6-9 months but we do think this will be the big decision over the coming 12-18 months.

Ripple effect

Clearly, where someone is using someone else’s money, a rise in interest rates leads to a ripple effect across the entire community, and in this case, possibly across the whole world. As the UK has just demonstrated however, the economy takes around about 12 months for any effects to be felt. Be warned; markets react quicker and can take into account the future impact in tomorrow’s values today however!

Understanding this relationship is how we can make better investment decisions. So what can we plan for? Well, for 10 years, we have had too much money chasing too few assets, often property, which has benefitted all those holding these assets. An increase in interest rates or a reduction in quantitative easing will reduce the amount of money in circulation by making money more expensive to obtain, and this is how interest rates affect equities. In normal circumstances, this should lead to asset depreciation.

This reduction leads to people and companies spending less on discretionary items, which reduces business revenue in these areas. Other businesses with borrowings are also affected as this may bring higher costs, or borrow less, meaning lower investment and a slowdown in business growth or even cutbacks. The usual result; lower real earnings, higher unemployment and a fall in the stock price.

Banks in Switzerland are paying negative interest rates, while banks in Italy are struggling. Combine this with factors highlighted in this article and, even ignoring the issues that the EU has with Brexit, Greece, Poland and other southern EU countries, this is a toxic mix.

However, the fact is that the interest rates have not risen in most countries. The EU and Germans appear to suggest that they are content to continue underwriting the Euro, while Brexit is an unknown problem for the EU and property prices in mainland Europe and the US are still rising. Whilst interest rates affect equities, the confidence of investors and economists remain strong at the moment; we will see how this changes with events. We will keep this tricky subject under review at our meetings.

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End of article: Investment advice linked to how interest rates affect equities

The views expressed in this article are not to be construed as personal advice. You should contact a qualified and ideally regulated adviser in order to obtain up to date personal advice with regard to your own personal circumstances. If you do not then you are acting under your own authority and deemed “execution only”. The author does not except any liability for people acting without personalised advice, who base a decision on views expressed in this generic article. Where this article is dated then it is based on legislation as of the date. Legislation changes but articles are rarely updated, although sometimes a new article is written; so, please check for later articles or changes in legislation on official government websites, as this article should not be relied on in isolation.

This article was published on 23rd November 2017


“About

James Pearcy-Caldwell

I have lived in various countries, but always remained firmly attached to the good old UK. My only goal is to take the experience and insider knowledge that I have, and be transparent with people so they understand the impact of their decisions.

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