The snow-laden first quarter of 2018 may seem a distant memory following the heatwave we have just been basking in. However, it was enough to slow economic activity and divert the Bank of England’s Monetary Policy Committee (MPC) from raising interest rates in May. A robust second quarter of growth statistics has now emboldened the MPC to go ahead.
Interest rates have been increased for the second time in less than a year. Perhaps more symbolically, rates are above the level they first fell to on 5 March 2009 – since when nine years have passed, we’ve had three general elections, 3 million more people are in work and the FTSE 100 has more than doubled.
A number of factors have delayed the rise in interest rates. The restoration of the national finances has been a significant factor. The budget deficit (how much additional borrowing the government incurs each year) was touching 10% of GDP the last time interest rates were above 0.5%. Now it is less than 2% of GDP, and the smallest it has been since 2002. The improvement has come at a cost: the infamous policy of austerity has depressed demand.
More recently, despite the weather-affected first few months, the UK economy is now expanding resiliently, and the employment market remains strong. That gave the MPC the opportunity it needed to raise interest rates. Whilst the first quarter might have been a dilemma for the MPC, because inflation was high whilst growth was weak, the only question this time around was whether the inflation outlook justified a hike. Clearly the MPC felt it did.
How will higher rates affect the economy?
The impact of this move is likely to be modest. Interest rates are still very low by historical standards and in recent years consumers have been switching their borrowing to fixed rate loans. Some 93% of new mortgages are fixed rate, according to the Bank of England’s latest figures. In addition, 65% of loans outstanding are fixed, twice the figure of a few years ago.
That said, the house price outlook across the United Kingdom is mixed. In London, prices are falling, and look set to continue to do so, and the weakness is rippling out to the rest of the South East. Elsewhere, prices seem to be accelerating again.
Part of the difference is the affordability of housing in the capital. Brexit is also a factor, as the prospect of some job losses, following loss of access to the single market for services, seems increasingly likely.
We expect job losses to be modest, but much will depend upon the final Brexit deal (or absence thereof). In a no deal scenario, we can expect the MPC to respond by easing monetary policy, even though this would likely come in the face of a significant devaluation of the pound which, together with import tariffs, would likely cause a one-off increase in inflation.
We expect that outcome to be avoided. However it is unlikely to have been settled by November, the next ’sensible‘ time to consider raising interest rates. No doubt that too was a factor influencing the MPC’s decision to raise rates today. It may have been its last opportunity to do so before May 2019.
How will this affect my investments?
This interest rate hike had been anticipated, so there is unlikely to be too much to get excited about from an investor’s perspective.
Generally higher interest rates make shares less attractive, but the difference between stocks, yielding 3-4%, and cash returns remains historically cavernous. Although the FTSE 100 is near record territory, we still expect higher returns from equities than cash or bonds.
Interest rates can affect the pound as well. Because this interest rate hike was expected we didn’t see the pound rise, but if rates were to increase further then the pound
would strengthen, reducing the value of overseas stocks or companies that sell most of their goods overseas. Under such circumstances, we would respond by increasing the element of domesticallyfocused companies in your portfolio.
However, given the delicate political situation, which will carry more weight as the year goes on, we think the pound will now face some headwinds. When rates rose last November the pound fell, because of the suggestion that rates will only rise very gradually.
Overall, this rate rise is not a game-changer. Even after this latest increase, the base rate is still close to its lowest point in history and is well below expectations for inflation. The stock market continues to offer the best opportunity for generating inflation-beating returns.
Guy Foster, Head of Research: Guy leads Brewin Dolphin’s Research team ensuring that a rigorous and exhaustive investment process is employed. He also provides recommendations on tactical investment strategy to Brewin Dolphin’s investment managers and strategic recommendations to the group’s Asset Allocation Committee. Before joining Brewin Dolphin in 2006, Guy was an Investment Director at Hill Martin (Asset Management). Guy has a Masters in Finance from London Business School. He is also a CFA charterholder, holds the CISI Diploma, and is a member of the Society of Business Economists. Guy frequently discusses financial issues with the written and televised media as well as presenting to the staff and clients of Brewin Dolphin.
The value of investments can fall and you may get back less than you invested. Past performance is not a guide to future performance. No investment is suitable in all cases and if you have any doubts as to an investment’s suitability then you should contact us. The information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.