Early this month, the Bank of England announced they were raising interest rates to 4.5%. This is a 45 fold increase in interest rates from the 0.1% rate 18 months ago.
Whilst anything can happen, there is a general market expectation that rates may creep up a little more before potentially creeping down a little at the end of this year into early next year. We are now in a dramatically different environment to the years of low interest rates since 2009.
The reason given for the high interest rates is to combat inflation. The target set for the Bank of England is to have inflation around 2% and it has been persistently above that target since the middle of 2021, with CPI sitting at 10.1% presently. The biggest contributor to inflation is food and energy prices. Food is currently up 19.1% in the last 12 months, with gas bills up 129% (according to the Office for National Statistics). With the main cost of food being ultimately fertilizer which is created using natural gas, we can see that the core of inflation woes is energy prices. Politicians would love to keep it simple – it is all the fault of the war. But in reality there are a number of factors that affect gas bills including: The strength of Sterling, seasonal demand and hidden costs in your gas bill. With the international cost of gas having recently fallen back sharply to 1990 levels its not really the global price of gas that is the issue (in dollar terms gas was 6 times more expensive in 2006 than today). When you look closely into bills, administration costs, tax and environmental levies make up two thirds of the bill (according to OffGem).
These costs are not really something that a tougher lending environment will rectify. However, a higher interest rate sets a new baseline for investment returns in the UK. Whilst you might have lent to the UK Government for 10 years at 1% interest 18 months ago, investors are asking for nearly 4% today. Those old bonds are still paying the same annual coupon and still have 8.5 years to go, but the only way to make them yield 4% is for the overall price to be lower today so that the coupon plus the recovery in price over 8.5 years equates to 4% a year. There is a similar maths for shares and property. So whilst the annual income/rent/dividends may be the same today as they were 18 months ago, the sale price of the whole Bond/Property/Share is lower. Interest rates therefore have a large effect on short term prices. Long term returns are of course driven by the accumulated profits from the investments.
All eyes are therefore on inflation and interest rates. With higher interest rates, higher taxes and Quantitative tightening (reversing the Covid money printing) combining to dampen demand and spending, there does seem to be an expected reduction in the inflation rate on the horizon and certainly the Bank of England and Government are predicting this. With less dramatic inflation rates we clear the way for interest rates to stop rising. This will provide stability for investment markets and help short term prices. Long term of course, we remain focused on the long term underlying profits that the investments are generating.
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 at all risk levels, 2023 has seen a small recovery with gains year to date. All eyes are on interest rates and the hope that inflation starts to fall in the coming months. Once inflation begins to fall towards government long term targets, this should result in the pausing of interest rate rises and potentially a reduction as we move into 2024” says Paul Gibson, director and chartered financial planner
“as always, investing should be for the long term and we should expect periods of negative performance. Sticking to the long term plan and remaining invested will give the best chance of achieving your financial goals”
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, Monday 15th May 2023