After a tough year for most investment markets in 2022, it has been a brighter start to 2023. One of the key reasons is a growing expectation that key central banks are nearing the end of the aggressive interest rate cycle. But why is this important to investors?
After remaining below 1% since 2009 UK interest rates have dramatically risen in the last year to 4%. Similarly in the USA the Fed Funds rate is now 4.75% and the European central bank has set its rate at 3%. Put simply, the interest rates received on cash savings now looks relatively more attractive than a year ago and therefore the higher interest rates go, the less relatively attractive the annual profits from assets looks. Similarly higher interest rates make it more expensive to borrow and therefore businesses, households and governments have to pay more on interest payments and less on growth and spending.
Why would central banks raise interest rates so sharply and quickly then? Surely the lower the better? The issue is inflation. After averaging around 2.5% for the last 2 decades, the consumer prices index rose to 10.7% by the end of November 2022. Prices are soaring, or put it another way, the pound is becoming dramatically less valuable compared to the cost of living. Inflation can become self-fulfilling if out of control inflation causes the pound to weaken and raises the prices of imported goods and increases inflation again.
Higher interest rates are intended to lower inflation. The intention is to deliberately weaken demand. If things and borrowing become more expensive, consumers tighten their belts, companies contract and a general cooling of the economy occurs.
If the Bank of England gets it just right then we have what is known as a “soft landing” (think of a gentle landing for a plane). They raise interest rates just enough to cool inflation to moderate levels but without tipping the economy into a deep recession. One of the difficulties for the Bank of England is that the data they are working off takes a long time to be produced. We get estimates and revisions of various economic numbers but they are usually revised many months after the event. The Bank of England is partly “flying blind”. This is notoriously difficult.
The latest meeting of the Bank of England resulted in a 0.5% interest rate rise but was accompanied by “Dovish” or “Soft” language that interest rates may be at or near peaking. With US rate rises slowing to only 0.25%, and additionally China reopening after it’s zero covid policy, markets have been behaving more optimistically so far this year. Markets would sorely like the pain of higher interest rates to stop as soon as possible. Whilst we must always remain vigilant against getting ahead of ourselves, the storm clouds of 2022 do seem to be abating somewhat and we will all be happy when we see that economic “plane” touch down gently onto the runway of a stable economic situation.
Quilter Cheviot is one of the largest discretionary investment management firms in the UK. Fraser Wilkinson (pictured) is Executive Director & Head of Leeds Office.
“After a tough 2022 for investment portfolios we have seen a more positive start to 2023 which will be pleasing for investors” says director and chartered financial planner, Paul Gibson
“whilst interest rates may continue to rise in the coming months it does seem as if the rate increases will be smaller as we approach the ‘peak’. The commentary issued from the Bank of England has given markets a boost as we have seen the FTSE100 hit record highs and whilst we may see some volatility in the coming months the long-term picture looks a little more settled”
Investors should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future return. You may not recover what you invest.
Approved – Quilter Cheviot Ltd, 17th February 2023