After Bank of England governor Mark Carney’s statement last month that a rate hike was probably coming sooner than expected, despite a unanimous vote to keep the benchmark rate at 0.5%, the market has been preparing for a change by the end of the year. The question for investors is how much the expected hike has already been priced in to rate sensitive stocks.
“Investors are increasingly focusing on the prospect of a UK interest rate hike, as witnessed by higher 2Y gilt yields, rising interest rate expectations and stronger GBP,” write Morgan Stanley analysts Graham Secker and Hanyi Lim. “Within equity markets, the sector and size rotation we have seen since early March fits with the historical performance patterns seen around the start of prior interest rate hiking cycles… Investors are asking whether a UK rate hike is now ‘in the price’ for rate-sensitive stocks.”
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Rate hikes accompany economic growth
Secker and Lim point to two different long-term trends that could affect investors: improved earnings and large cap outperformance during periods of rising interest rates. Improved earnings is to be expected, and it’s less obvious how you would actually put this correlation into practice as an investor. UK interest rates have mostly fallen since 1990, and spent more time falling than rising between 1978 and 1990, while UK equities have been rising with the exception of the two crises. Add in the fact that central banks will usually increase rates when the economy is strong and drop them when it is weak and the correlation is what you would have expected. Since 1970 the annualized growth rate for UK equities is 7.4% compared to 9.9% during periods of rising rates.
Along the same lines, EPS doubles during periods of rising interest rates, from an average growth rate of 7.3% since 1970 to 14.5% when rates are going up, and PE tends to de-rate as the growth in EPS outpaces the increase in stock prices.
Interest rate hikes favor UK large-caps
What’s more interesting is that large caps relative performance benefits from interest rate hikes because of a relative value re-rating.
“Although interest rate hikes do not usually derail the equity market over the medium term, we do note a change in the behaviour of size indices,” write Secker and Lim. “During prior periods of interest rate hikes the underperformance of FTSE 100 (INDEXFTSE:UKX) versus FTSE 250 (INDEXFTSE:MCX) slows materially and we actually see outperformance of FTSE100 over FTSE Small Caps.”
The 1994 rate hike caused the FTSE 100 to outperform by 12%, while the 2003 – 2004 rate hike period halted a period of falling relative performance in its tracks.
FTSE 100 outperformance already exceeds what is normally seen in the period around interest rate hikes, but Secker and Lim still think they offer attractive prices, standing by their Overweight large-cap stance, even though some of the gains from a rate hike have already been priced in.