Last Thursday, the Bank of England’s Monetary Policy Committee unanimously voted to increase the UK’s interest rate by 25 basis points to 0.75%.
Given the rate stood at 5% a decade ago, such a rise may not seem too significant in absolute terms – although of course, relatively speaking, it is now half as high again as this time last week, which should give mortgage-holders pause for thought, as we discussed in 'Home truths'.
Investors should also care about rising interest rates – a point easily illustrated by addressing the question of how much someone would have to give you in a year’s time for you to hand over £100 today?
Assuming it is guaranteed they will pay you back, is it £105? £107? £110? The amount that would make you ambivalent about whether you had the cash today or received it in the future is known as the ‘time value’ of money.
The percentage difference between the two numbers, meanwhile, is known as the ‘discount rate’.
The discount rate and interest rates
There is an extremely strong link between the discount rate and the interest rate and this is because, if you had £100 today, you could put it in a bank account and earn interest over the coming year.
The more you can earn in interest, therefore, the greater the amount you need to receive in the future to compensate you for not receiving that interest.
If, for example, interest rates were currently 10%, you would not accept less than £110 in a year’s time as, obviously enough, you would otherwise be better off taking your £100 as it is now and stashing it away in a bank account.
When interest rates are 0%, however – as they effectively still are today – the future amount you would accept for your £100 now is likely to be lower. In this scenario, perhaps £102 would suffice.
We can also turn this question around.
What return do I need in future?
Thus, if we know we want to receive £110 in three years’ time, say, how much would we need to set aside now?
The answer to that question would again depend on where interest rates stood. If interest rates were high, you might only need to set aside £100. If they were low, however, the amount might be closer to £108.
This, in effect, is the sum the stockmarket is trying to solve – and why interest rates move share prices.
While the value of a theoretical company in, say, 2030, may not move in itself, a reduction in discount rates triggered by a reduction in interest rates will have an effect.
If, then, that company was seen as worth £110 in 2030, with interest rates high, the share price today may be £100. With interest rates low, the company may be worth £108.
Low interest rates and high stock prices
The reduction in interest rates that has been seen around the world since the financial crisis struck a decade ago has had precisely this impact on stockmarkets globally.
It should, in other words, come as no surprise that share prices have seen a succession of all-time highs in different countries – at a time of historically low interest rates, such moves are totally understandable and justified.
That said, investors need to remember the mantra intoned by central bankers around the world as they responded to the credit crunch by cutting rates to these levels was ‘lower for longer’ – not ‘lower for ever’.
In the UK, given last week’s decision to increase the benchmark borrowing rate to the highest level in 10 years, it would appear we are now at the edge of what the Bank of England would consider of ‘longer’.
While the impact that will have on markets is impossible for anyone to predict with any certainty, here on The Value Perspective, we believe we can say two things with some confidence:
- A market that has become used to low rates is likely to have some adjustments to make.
- In the process of making those adjustments, the market is likely to overreact in some areas, creating opportunities for stockpicking investors.
In 'Gradually rising', we warned against investors being too confident about how interest rates will behave in the coming years – and we sincerely hope the move to what might be considered a more ‘normal’ interest rate does not prove too painful.
That said, our value-oriented investment process is specifically designed to take advantage of emotion and overreaction within the wider market and more than a century of history suggests we – and our investors – should benefit from the sort of environment likely to prevail in that eventuality.