Bank of England Deputy Governor Ben Broadbent said last week that there might be more interest rate rises than futures markets are pricing in. Equity investors should worry less about this, though, and more about what such rises would mean for gilts.
I say so because the effect of changes in short-term interest rates upon the All-Share index is generally small and often positive. For example, looking at annual changes since 2002, the correlation between the two is 0.33. This implies that rising rates are more usually accompanied by rises in share prices rather than falls, albeit not by much.
One big reason for this is that rate changes have two effects upon equities, which tend to offset each other.
One is causal; markets expect higher interest rates to cause slower growth, which hurts shares.
The other is diagnostic. Rates only rise if the Bank of England believes the economy is strong enough to withstand or require tighter monetary policy – a belief often shared by investors. But of course, a strong economy is good for equities.
For the aggregate market, the statistics tell us that the latter effect has been slightly more important on average.
If we look at individual stock market sectors, however, a different picture emerges. Here, we must distinguish three different categories.
| Impact of interest rate changes on FTSE sectors | ||
| 3-mth rate | 10-year yield | |
| Construction | 2.9 | 4.7 |
| Transport | -1.6 | 10.1 |
| Tobacco | 4.4 | -9.1 |
| Pharmaceuticals | -3.0 | -3.0 |
| General retailers | -6.4 | 10.7 |
| Telecoms | 2.7 | 5.0 |
| All-Share index | 1.8 | 10.5 |
| Based on annual changes since Jan 2002 | ||
The first are those stocks that benefit when both short rates and longer-term gilt yields rise. Based on correlations in annual changes since 2002, these include the construction, telecoms and healthcare sectors. You might be surprised that construction benefits from rising rates. But you shouldn’t be. This just tells us that rates rise when the economy is doing well – which is often when construction stocks are rising.
This finding might be especially relevant now. I suspect that if rates do rise, it’ll be because we get a looser fiscal policy – and beneficiaries of this might well include construction.
Beyond this group, however, what matters is how gilt yields react to rising short rates.
One possibility is that they also rise. This would happen if markets expect better medium-term economic growth, say as a result of a fiscal loosening.
Winners from this process would include transport and general retailing. Both have tended to do so well when yields rise as to offset the adverse effects of higher short rates. Other beneficiaries include general financials, food retailing and the All-Share index itself.
This is much as you’d expect. Many cyclical stocks should benefit from rising gilt yields, to the extent that these betoken stronger economic activity.
There is, though, another possibility. If markets fear that rate rises would curb future growth significantly, gilt yields would fall. This would hurt cyclicals but would benefit other stocks such as tobacco, beverages and oils. These tend to be defensive stocks – the sort that investors shift towards if they anticipate bad times.
These yield curve effects are important. In many cases, they outweigh the impact of changes in short rates alone. Take for example general retailers. Since 2002 each percentage point rise in short rates has been accompanied by a fall on average of 6.4 per cent in the sector. Only IT stocks have a stronger adverse response to rising rates. However, each percentage point rise in ten year gilt yields has been associated with an average 10.7 per cent rise in retailing shares. This tells us that retailers are more sensitive to long rates than to short ones. And this is true of most sectors: engineers, IT and utilities being the main exceptions.
It’s also true for the general market. Each percentage point annual change in short rates (controlling for changes in gilt yields) has been associated with a 1.8 per cent change in the All-Share index – which is statistically insignificant. But each percentage point rise in gilt yields has been accompanied by an average change in the market of 10.5 per cent.
The question for stock pickers, therefore, is not so much the direction of short rates but rather what they do to the yield curve. If this stays the same or steepens – that is, if gilt yields rise as short rates rise, cyclicals will win. If however it flattens then they lose and defensives win.
Personally, I wouldn’t want to bet heavily either way. For what it’s worth, my hunch is that while cyclicals might benefit in the short-term, defensives might win out longer-term. Given that defensives usually beat the market on average for other reasons, they are worth hanging on to.
