Yesterday, the Bank of England rattled financial markets by warning that UK interest rates may rise for the first time in a decade "over the coming months."
While the bank's nine member Monetary Policy Committee (MPC) voted 7-2 to keep interest rates on hold at a record low of 0.25% for now, it advised that rates may be raised in the near-term. The central bank has concerns that inflation is on the rise, and said that "some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target." The bank's official inflation target is 2%.
So what are the potential ramifications of an interest rate rise on your share portfolio? Let's take a look at how rate rises affect the stock market.
Conventional investment theory suggests that there's an inverse relationship between interest rates and stock valuations. Stock prices are related to company profitability, and higher interest rates should increase borrowing costs and erode company profits, therefore decreasing stock prices.
Furthermore, as risk-free interest rates rise, the yields on risky investments become less attractive. So bonds that have 'fixed' interest payments and 'bond-proxy' type stocks that are popular for their solid dividend payments, should in theory fall in value if interest rates rise.
Thirdly, a rise in UK interest rates should boost sterling, which may reduce the profits of companies that generate earnings overseas. With these theories in mind, it was no surprise to see that companies influenced by these factors were sold off yesterday, with stocks such as Unilever and British American Tobacco falling by 1%-2%.
However, before you hit the sell button, there's a few things to consider.
At the moment, the Bank of England has just hinted that it may raise interest rates. There's no guarantee that it actually will, especially with Brexit uncertainty lingering.
Also, if the bank does increase interest rates, it's likely to be by a very small amount such as 0.25%. The returns offered on savings accounts will still be abysmal, and as such, the returns from the stock market should easily continue to outperform cash over the long term.
A look back to 2006/2007
Furthermore, sometimes economic theories simply don't pan out as the textbooks say they will.
For example, if we look back a decade ago, the Bank of England raised rates significantly between August 2006 and July 2007, as shown in the table below.
Source: Bank of England
How did the FTSE 100 perform in this time? The index actually rose from around 5,900 points to 6,650 points, a gain of approximately 13%.
What to do
The lessons here? Don't panic about an interest rate rise that may or may not happen. As a long-term investor, it shouldn't make a difference to your investment strategy. Focus on buying high-quality businesses, when they are trading at attractive valuations, and hold them for the long term. This strategy has proven to be successful in the past, no matter what interest rates are doing in the short term.
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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.