The impact of higher interest rates on equities

He says it is possible to “alternate between” the recovery and the expansion stages for a long time without ever entering the recession stage. 

Interest rate policy in such a climate is predicated on the economy being well into the expansion stage, with inflation rising as demand outstrips supply. 

In that phase, most companies are growing, so investors are less willing to pay a premium for growth because every company is growing, and so, instead, focus on the valuations of individual companies, a style known as value investing. 

Rising interest rates are both a portent of, and a cause of, value stocks doing well.

If central banks have got their decisions correct, then they will be lifting rates as a result of strong economic growth and rising inflation.

The growth should mean most companies are doing well, like businesses such as miners and oil companies that have the capacity to raise their prices even as inflation rises, and banks, which benefit when higher inflation turns into higher interest rates, as they can earn more from their loan book. 

In addition, economies in the expansion phase, when inflation is high, are likely to see a sell-off in bonds. 

This will suppress bond prices and because lower bond prices means higher bond yields, this can be negative for income-paying equities, as investors can obtain that income from the lower risk asset class of bonds. 

Putting interest rates up also typically means bond prices fall because investors can get an increased return on cash, and so have less desire to own bonds. 

Exit to nowhere

So higher rates may push bond investors into cash, and equity investors into bonds, with equities falling. 

But rate rises also matter for the signal they send, as they indicate policymakers are worried about the inflation rate, and that the economic cycle is advanced, and we may be closer to the downturn phase, and so investors may want to own fewer equities anyway.   

At such times, investors may feel that the prudent course of action is to move away from the most economically sensitive areas and into those sectors that can maintain some level of growth even if the economy is struggling.

Charlie Parker, managing director at Albemarle Street Partners, says he has recently been reducing his UK equity exposure and moving back towards the US.

US equities outperformed most other markets in the period when interest rates were low, though the UK outperformed in January, when value stocks were in favour. 

Parker says he believes inflation is close to peaking, and when it does, the present strong performance of value stocks will begin to decline.