Will rate rises cast a dark shadow over equity hopes?

For income-seekers the FTSE 100, with its relatively high yield, is not a bad place to be, says Garry White

Interest-rate rises are bad for equities because companies end up paying more interest on their debts. This eats into margins and profitability – so is negative for stock market valuations. The Bank of England is expected to start increasing interest rates sooner rather than later, which must be a negative for the FTSE 100. Or is it?

Not necessarily. Any rate rises are likely to be small and the tightening cycle is likely to be pretty lengthy. Janet Yellen, Federal Reserve chair, and Mark Carney, Governor of the Bank of England, have both indicated many times in speeches over the past few months that they do not plan to do anything rash. Neither would want to take responsibility for upsetting a delicate recovery from the worst economic crisis since the Depression.

We are unlikely to get back to “normalised” interest rates for quite some time. The timing of any interest rate increase depends on the pace of wage increases and productivity developments, as well as on the continuing low inflation rate. UK monetary policy may have to remain fairly accommodative to balance the Government’s relatively tough fiscal stance. It is possible interest rates could be as low as 1.5pc even in 2018.

The City understands this – and a broad sell-off at the turn of the cycle is therefore unlikely. My money is on the FTSE taking the first UK interest rate rise in its stride. Also, it is important to remember that the asset class that gets hit most directly by interest-rate rises is bonds.

This Goldilocks scenario is helped by the fact that inflation isn’t really a concern at present – and equities can act as a hedge against moderate inflation. That’s because companies have the ability to pass on small price rises to their customers – and it is only when inflation starts to become significant that it leads to a major squeeze on margins.

Also, the constituents of the FTSE 100 make domestic policy less relevant to its performance. The vast majority of earnings in the FTSE 100 come from outside the UK. The index is one of the most international in the world, so it is movements in currency markets that actually affect the index most. The pound has been strengthening ahead of the expected rate rise, so a large proportion of any currency moves is likely to be priced in.

One big uncertainty for the FTSE 100 is commodity prices. The slide in oiland metal prices was the main reason the UK benchmark underperformed other developed indices in 2014. The three largest oil companies – BP, Royal Dutch Shell and BG Group – alone make up 13.3pc of the index by weight. The miners make up a further 5.6pc of its weighting. The current environment makes it extremely difficult to predict how these sectors will fare in the coming months. Any recovery in the oil price could provide a significant boost for the FTSE, although not even executives at oil companies are expecting this to happen any time soon.

The argument in favour of continued equity ownership lies partly in recognising that, although shares appear fully valued, they are not yet at the extreme levels of valuation identified at the peak of previous “bubble” periods in 2000 and 2007. This is despite the fact that M&A activity has strengthened again and IPO activity has picked up – both indicators of potential froth in markets as they approach their peak.

It is asset allocation, rather than individual stock-picking, that is a more important factor for investors looking to make money. Although any rises over the summer are unlikely to push the FTSE 100 significantly out of bed, there may be better opportunities to make money outside the UK, despite the fact that equity valuations do not appear overly expensive.

This is particularly true in regions where equity markets are likely to be supported by unconventional policy such as quantitative easing by central banks – that is, Europe and Japan.

Another market employing unconventional policy in terms of its equity market is China. Its recent fall into a bear market may have piqued the interest of some investors. In July, Chinese shares suffered their worst month since August 2009, with the benchmark Shanghai Composite Index down 14pc in July and 29pc lower than its June peak. However, significant government interventions helped the index rebound from its July low by 18pc.

The authorities decided to move boldly to arrest the self-fuelling decline. The government cut interest rates, loosened collateral requirements for loans, allowed roll- over of margin positions, relaxed bank requirements and finally announced a major share-buying programme. Some people were told not to sell shares and some institutions were required to buy and hold equities to help halt the rout.

China remains a special case. The long-term argument for investing in China is undeniable. However, the market weakness and sharp increase in volatility is testing that thesis over the short term.

So, although conditions appear reasonably supportive for the UK blue- chip index over the next few months, it could be argued that more exciting opportunities can be found elsewhere. This means that, if pushed for a rating on the FTSE 100, the sensible stance seems “neutral”, with a recovering eurozone looking interesting from an asset-allocation point of view.

For income-seekers, however, the FTSE 100, with its defensive bias and rela

tively high yield, is not a bad place to be.

Garry White is Chief Investment Commentator at Charles Stanley