Bank of England governor Andrew Bailey may have earned the tag of an ‘unreliable boyfriend’ after the Bank’s Monetary Policy Committee confounded market expectations and kept interest rates at record lows at its latest meeting (4 Nov), but the message was clear: rate rises are coming.

Mounting inflation means the Bank of England must do something and investors need to be prepared.

In this article we consider what rising rates mean from a market perspective and how it might impact stocks and sectors depending on their various sensitivities to rates.

ARE RATE RISES BAD FOR STOCKS?

Received wisdom is that an increase in interest rates is bad news for stocks and shares as they boost the attractiveness and returns on offer from lower risk assets like cash.

The evidence, in the form of the FTSE All-Share’s performance during periods when rates are in an upwards or downwards cycle, backs this truism up, though only to a limited extent.

This makes sense given changes to interest rates don’t happen in a vacuum and there are lots of other influences on how stock markets perform and often when rates are rising it’s because the economy is doing relatively well.

The most obvious example of rate increases accompanying a pronounced fall in the markets comes in the mid-to-late 1970s when the UK endured a period of stagflation, which is rising inflation and slowing growth.

There are some fears we could see a repeat of this damaging economic trend now as shortages and supply chain issues lead to rising prices but also choke off the recovery from the pandemic.

HOW FAR AND HOW FAST WILL THE BANK RAISE RATES?

Investors must consider just how far and how fast the Bank will increase rates. While they will almost certainly go up, some observers believe they won’t move by much.

While delivering his Budget in October chancellor Rishi Sunak noted the country’s public finances were twice as sensitive to an increase in rates as they were before the pandemic and six times as sensitive as they were before the 2007/8 financial crisis. That suggests the Bank of England needs to tread carefully.

Capital Economics’ chief UK economist Paul Dales said the Bank’s latest decision did ‘throw on the bonfire the markets’ expectations that interest rates will rise to 1% by the end of next year. This provides some support to our view that rates will end next year at 0.5%’.

IMPACT OF HIGHER RATES ON THE POUND AND HOW THAT AFFECTS THE FTSE 100

Typically, higher interest rates increase the value of a country’s currency.

A stronger pound would be negative for the FTSE 100 because of the high proportion of sales and revenues made by blue-chip companies in dollars, estimated at about 70% of the index. If sterling strengthens then dollar revenues, once converted back into sterling, are worth less.

But the traditional link between higher rates and a stronger currency isn’t holding given other factors in play, such as doubts about the robustness of economic recovery, Covid cases increasing and sky-high energy prices squeezing consumers and industry.

We can see this broken linkage over the past three months. Despite many finance experts and the market increasingly anticipating rate rises late this year, and certainly into 2022, the pound has fallen against the greenback, losing about 2.5% since early August.

That might not seem like much but on such relatively meagre margins fortunes can be won and lost, savings pots preserved or eroded given the millions, even billions of pounds of exposure worn by financial institutions and large companies.

For example, energy, basic resources, industrials and healthcare stocks make up more than 40% of the FTSE 100 market weighting, according to FTSE Russell data, sectors that are almost exclusively dollar earners.

This implies that if the pound does start to firm down the line, then profits, cash flows and potentially dividends from the likes of large cap stocks including BP (BP.), Unilever (ULVR), AstraZeneca (AZN), miners and many others could come under pressure.

A lot of investors may think the FTSE 250 is safer territory on the assumption that it is more representative of the UK economy as it contains mostly domestic businesses. This is not quite the case as something like 50% of sales and profits from members of the FTSE 250 still come from overseas.

According to a recent Bloomberg survey, strategists have shifted and see the pound stuck around current levels over the next few months. The median year-end forecast is now $1.37, down from as high as $1.43 four months ago.

At the time of writing, the pound traded at $1.35, having weakened after the Bank of England’s decision on 4 November not to put rates up yet.

WILL BANKS REALLY BENEFIT FROM HIGHER RATES?

Traditionally banks have been viewed as being a key beneficiary of a rising interest rate environment. This is because they have a greater scope to increase their net interest margins (the difference between the rates at which they lend money and the interest they pay on customers’ savings) when interest rates are rising. However, there is a potential future situation which could dampen profit accretion.

At present the UK financial sector has £900 billion of cash reserves that are remunerated at the Bank of England’s base rate. However, there is risk this may change.

The recent Covid-19 pandemic has resulted in a marked increase in the public sector borrowing requirement. This means that Government debt is particularly sensitive to any increase in interest rates.

This logic extends to the banking sector’s reserve balances. Numis estimates that for every 25 basis points increase in the base rate, applied to £900 billion of reserve balances, this could add £2.3 billion to the public sector borrowing requirement.

Numis says there are major implications on the UK banks if half of their reserve balance stopped receiving interest at base rate.

The sector’s sensitivity to higher rates could be reduced by 40% to 50%. The positive impact on domestic sector profits of a 25 basis-point UK rate rise could fall from 5% to 3%. At NatWest (NWG), which is the most rate sensitive, pre-tax profit accretion would fall from 11% to 7% because of the move.

WATCH OUT FOR LOW MARGIN COMPANIES

Rising interest rates could put pressure on family finances and impact discretionary spending on big ticket items and ‘nice-to-have’ purchases.

To find potentially vulnerable stocks, investors should look at consumer cyclical stocks that have wafer-thin margins and high operating leverage.

The latter means a company has a high proportion of fixed costs which means profits are more sensitive to a fall in revenues. A relatively small drop in sales can have a disproportionate impact on earnings.

Conversely, businesses with high margins and low operating leverage are more resilient to falling revenues and are better able to absorb a drop in revenues and inflationary pressure.

GOOD NEWS FOR COMPANIES WITH LARGE PENSION DEFICITS

Higher interest rates can lead to a reduction in the liabilities of corporate pension schemes, potentially benefiting companies with big deficits.

That’s because pension liabilities are comprised of future pension payments and most schemes match those liabilities by buying long-dated bonds. Actuaries value long-term liabilities by applying a discount rate which is linked to interest rates. Actuaries are specialist statisticians who provide services around modelling risk and uncertainty.

If interest rates rise, pushing long-term bond yields higher, actuaries can justify applying a higher discount rate which has the effect of lowering liabilities and reducing a deficit or increasing a surplus.

However, it’s not that simple because not all maturities of bonds respond in the same way to a rise in government interest rates.

For example, if investors believe that raising interest rates today will put the brakes on economic growth and reduce the level of inflation then longer-term bond yields might fall.

This may have the seemingly bizarre effect of lowering the discount rate that actuaries use to value liabilities. Therefore, to see a positive effect, long-term yields need to rise.

Telecoms group BT (BT.) has one of the largest pension deficits in the UK, worth over £5 billion.

The company has pledged to pay £900 million a year until 2030 to plug the gap, so if the deficit were lowered due to higher interest rates, it might be good news for international telecoms provider Altice, which has built a 12% stake and rumoured to be interested in buying BT.

A change to the regulation of pension funds has given trustees more influence in takeover situations, to protect the interests of              pension holders.

One word of caution, just remember that a company with a large pension deficit isn’t suddenly worth buying because it could benefit from rising rates. In theory, its share price might get a small bump, but you must always look at the fundamentals of the business and be comfortable with its growth prospects, financial strength and competition positioning before considering an investment.

WHAT HIGHER RATES MEAN FOR COMPANIES WITH LOTS OF DEBT OR CASH

An increase in interest rates is typically bad news for companies with lots of debt and good news for companies with plenty of cash on their balance sheet.

With this in mind, we ran a screen of the UK market using Stockopedia to identify stocks with a market value greater than £500 million and where net debt to assets is greater than 60%. This is a measure of indebtedness and is calculated by comparing net debt to total assets.

Net debt is total debt minus cash. Net debt to assets of 60% or more is often considered to be unsustainable. We excluded the financial sector because the complexity of their balance sheets renders such measures largely meaningless.

We narrowed the search further by insisting on an Altman Z-score of less than 1.2 times. The Z-score is designed to identify companies which have a higher risk of bankruptcy, with readings below the 1.2 threshold considered riskier than average.

It is no surprise to see plenty of travel, hospitality and leisure businesses on the list as they are bearing the scars of the pandemic. For an extended period, they incurred plenty of fixed costs but effectively generating zero revenue thanks to Covid restrictions. Inevitably this resulted in big increases in borrowing.

These businesses could face a double whammy from a rate increase. Interest costs may rise, although many firms will have fixed rates of interest at least in the short term.

At the same time consumers will see increased costs on their mortgages, credit cards and other loans at a time when they are already seeing rising fuel, food and energy prices.

This is hardly the platform for a boom in spending on leisure activities and holidays. It’s little wonder that many of these stocks have underperformed the market over the last six months.

On the flipside, companies with lots of net cash should be better placed in a rising interest rate environment. We used Stockopedia again to find firms worth more than £500 million with a price to net cash ratio of eight or less. This effectively means their market value is no more than eight times the value of their net cash.

The cash should earn a higher level of interest and these companies won’t be exposed to the same pressures as those firms which are weighed down by heavy debts.

Housebuilders feature heavily in this list of cashed-up stocks, though the downside for this sector of a rate increase is that it will reduce the availability of cheap mortgages for potential purchasers.

WATCH OUT FOR HIGHLY RATED STOCKS IF RATES RISE

Perhaps one of the market oddities of rising interest rates is that it can make the market far more short-term in its thinking.

In theory, if low risk returns become more attractive and more readily available, there’s less incentive to take higher risks on stocks where returns are less certain and likely to come further down the line.

This is particularly relevant in the technology space, where over-hyped companies may struggle to maintain current valuations against a backcloth of more predictable, lower risk (albeit lower return) investments.

That’s why investors could see investment flows shift from expensive stocks, such as those with price to earnings ratios of 30-plus, towards lower valued stocks and even cash in the bank as interest rates expand.

While we wouldn’t necessarily argue with the concept of lower risk assets for shorter time horizons, investors could run the risk of turning too cautious and ejecting higher quality stocks with the capacity for substantial wealth creation from portfolios.

If you have highly rated stocks in your portfolio, you might want to prioritise the ones with a track record of making good returns on capital employed rather than ones which are growing fast but where their higher valuation reflects jam tomorrow rather than jam today.

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