In a nutshell
- Although interest rates are expected to come down towards the end of next year, it’s likely they will be higher than what we’re used to over recent times.
- Central banks are keen to see inflation (the rising cost of living) show clear signs of coming down before they start making rate cuts – although they are also mindful of the risk higher rates could pose to the economy.
- Markets have largely priced in the idea of higher rates for longer. But when rates do start to come down this should be good news for stock markets and fixed income.
- Nevertheless, we expect periods of volatility which is why a diversified portfolio remains key to long-term investing.
All change for interest rates
In recent years we’ve seen big changes take place for interest rates:
- Central banks have applied the steepest series of interest rate rises in decades.
- On average, rates have been raised by around 400 basis points (4%) in developed economies since late 2021.
So why is this?
Well, it all started with the Covid pandemic. As the world locked down, we saw disruptions to supply chains meaning companies were unable to meet the demands of their customers. This was made worse by people having more money in their back pockets because they saved more from not spending as much during lockdown.
Each of these factors created the perfect backdrop for prices to begin rising to decade highs. Then in February 2022 Russia invaded Ukraine. The conflict initially led to higher energy and material costs, sending prices spiralling even further.
To try and tame those higher prices, central banks began rapidly increasing interest rates to their current levels. Which is why we find ourselves where we are today.
The good news is, so far the majority of economies have stood up well to those interest rate hikes. Economists and experts across the board seemed pretty sure this mix of higher inflation and interest rates would lead to a recession. That is yet to happen, but we’re not out of the woods yet.
Inflation is finally showing signs of coming down, and the general consensus is that rates have probably peaked. But what’s unclear is when they might start to fall.
Let’s take the UK as our main example
The Bank of England has left interest rates unchanged since September. The general consensus among investors is that we’ve seen rates peak and we could even see two rate cuts by the end of 2024.
Inflation remains a problem in the UK. Yes, it’s coming down (inflation fell to 4.6% in October, down from 6.7% in September). But it still stands more than double the Bank of England’s 2% target.
There are certain areas which are proving more stubborn when it comes to inflation. Although coming down, prices for services (hospitality, recreation, personal service) continue to increase. Meanwhile, energy bills could drive inflation back higher if they rise again.
The biggest challenge remaining is to bring wages back in line with the economy’s growth prospects. At the moment, incomes are growing faster than prices. Of course, this is a good thing for the economy, but it continues to make the Bank of England’s inflation target harder to meet.
Because there are currently more vacancies than people looking for work, firms are offering pay increases to attract new workers or to encourage existing employees to stay. Not only do higher wages tend to drive up people’s spending, but there’s also a danger inflation caused by wage increases becomes harder to shift than when it’s caused by the cost of goods.
This is a key factor in why it’s likely interest rates will remain higher for longer so the Bank of England can finish the job.
Bank of England officials themselves are keen to stress this idea too. At its November meeting, the main message was for households and businesses to prepare for a prolonged period of high interest rates. The meeting notes said interest rates must be “sufficiently restrictive for sufficiently long.” (Put simply, higher for longer.)
The Bank of England will watch carefully as to what impact this approach has on the economy. The longer interest rates remain higher, the bigger the challenge they pose to the economy and markets. Higher borrowing costs and reduced demand are two key ingredients for a recession. Any significant slowdown in economic growth might result in cutting rates sooner.
What about the US and Europe?
Like the Bank of England, other big central banks are pushing back against rate falls too.
Over in the US, the Federal Reserve are in a similar position. According to their latest meeting notes, they expect economic data in the coming months to help clarify whether inflation in the US is truly falling. Officials are of the firm belief that it’s appropriate for interest rates to remain higher until inflation is clearly moving downwards.
As for Europe, Christine Lagarde, president of the European Central Bank said that she wasn’t expecting rate cuts for at least “the next couple of quarters”. Inflation in Europe came in better than expected for November (from 2.9% in October, to 2.4% in November), but the European Central Bank were still keen to stress it’s too early to declare victory over price rises.
What do investors think?
It’s been a volatile year overall for markets. But as the year draws to a close, investors appear to be positive about what’s ahead next year for interest rates:
- Some are forecasting UK interest rates to remain unchanged until quarter two of 2024. Although rates aren’t expected to fall until the middle of next year.
- Investors are expecting the European Central Bank to start cutting rates early next year.
- In November, the MSCI World Stock Index (a representation of global stocks) had its best month in three years as investors became more confident the Federal Reserve and other central banks are getting closer to rate cuts.
For a good year now, it’s felt like investors hang to every word central banks say. It’s a fine balance for officials. They won’t want to come across as too pessimistic and cause markets to dramatically fall, but they are also keen to keep investors from getting too excited. Andrew Bailey recently said he was concerned markets were “underestimating” the persistence of inflation.
How could markets react when rates do come down?
The past couple of years haven’t been great for fixed income markets. Both inflation and interest rate rises hurt bond prices because the returns they pay suddenly look less attractive. (Inflation eats away at the value of the cash being paid out in the future.)
So to pay a more attractive return, bonds need to fall in price. This is what’s happened since 2021 when central banks first began to raise rates. Some of those losses should be recovered if interest rates begin to unwind. Just the idea that rates have peaked has proved good news – November was the best month for US bond markets since the 1980s as investors became more confident the US Federal Reserve is done with rate hikes.
Rate cuts might also be felt in stock markets. Lower rates should be positive for shares on the whole as it means better conditions for the economy. Plus, different parts of the stock markets will feel the effects differently.
When rates began to rise in 2022, it was growth companies that were worst hit. Growth companies are those which the market believes can grow their earnings steadily into the future (such as businesses in the technology sector). This can be because they are in expanding markets or making use of new technologies that are expected to grow in significance.
When inflation and rates rose, the expected future of these earnings became lower and share prices fell. But with an outlook of lowering inflation and interest rates, things could be looking a little more rosy for these types of shares. Meanwhile, value companies have fared better in the high interest rate environment. These are companies that may be producing strong earnings in the here and now, but look less likely to grow their earnings in the future (such as those in the energy sector).
When central banks raise rates value stocks tend to outperform the market and do better than growth stocks. This is because they are typically less reactive to volatility.
While inflation remains on the higher side and central banks keep rates at elevated levels, we’re bound to experience periods of market volatility – with ups and downs for all sides of markets. But this is simply a part of investing. And as we like to remind you, as someone who invests your money through Skipton, one of our main goals is to build you a diversified investment portfolio that’s designed to generate long-term growth. We aim to provide you with a balanced exposure to various investment styles and a mix of asset classes that could navigate the different conditions that can occur.
After a tough couple of years, some positive progress has been made with inflation in 2023. We’re now in a position where we can write articles about interest rates potentially peaking – with the potential of them coming down. Of course we’re not there just yet, but the outlook looks a little more promising.
Past performance is not a guide to future returns. Past economic and market conditions experienced may not be repeated in the future. The opinions and analysis provided are for information only and do not constitute financial advice.
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