The stock market and potential interest rate rises: what, why and how am I affected?

The markets have been in the news all week, what’s a market correction and why has it happened?

A correction is a significant pullback in the market prices. You have stock exchanges like the London Stock Exchange, AIM, New York or NASDAQ.  To measure their success, they’re put in leagues, or indices. In the UK the most common one we’re familiar with is the FTSE 100, and in the US it’s the Dow Jones.

When these indices pull back their prices by a certain percentage, it’s called a correction. Most experts set a correction as a 10% or greater drop in market value, but I don’t like to set specific labels like that because you can start to get emotionally tied to it and concerned about it. For me, it’s more about seeing the bigger picture: what’s happening, why is it happening and what’s the greater impact on the economy?

In 2007 we had the financial crisis, and to help the economy recovery from that we had a financial stimulus package put in place, which included quantitative easing (QE). Most of us, myself included, hadn’t heard of QE before, but now we understand that it’s the printing of extra money, used to buy back government debt. What that does is put a lot of extra money in the economy. Very slowly, that’s helped the economy recover.

Then over in the US we have a new president, and he’s a bit of a maverick. He’s slashed lots of banking legislation, and more recently has completed a lot of tax reform. He’s cut the US corporate tax rate from 32% to 20%, which has made it so attractive to companies like Apple that they’re repatriating tens of billions of dollars back to the US economy from overseas. That is a positive sign and it’s putting confidence in the economy, so the economy has been growing in the US. The US is around 51% of the world market cap/stock market size, therefore it’s having an impact on the global economy.

That’s the gas on the pedal, putting the accelerator down and going faster. On the other hand you have the Federal Reserve, effectively the police in this analogy, saying ‘Whoa, slow down,’ and their brake is interest rates. The Fed’s job is to say OK, we like the economy growing, but if we go too fast we get nervous. It’s like being on a rollercoaster, fast is OK but when it starts going too quickly and upside down they get nervous. So they put the brake on – which is a threat or intention to increase interest rates.

The stock market likes certainty. When it doesn’t know things, it gets nervous, and that’s what’s happening right now. The Fed and the Bank of England yesterday said they’re looking at raising interest rates. That’s not a bad thing, because if you’re a saver you want higher rates. And if you want a strong, stable economy, you need higher interest rates than we have now.

Why? Because if the economy slows – in fact, when the economy slows – we need another stimulus available that isn’t quantitative easing. We don’t just want to keep pumping more money into the economy. If the interest rates are at around 3% when the economy slows, that allows the Fed and the Bank of England to reduce interest rates, in turn stimulating the economy.

How does this relate to us?

Stock market correctionInvestors

It’s all about timeframe. Let’s look at investors to start off with. If you need access to your money within the next 5 to 7 years you should not be heavily invested in the stock market. We’ve experienced pullbacks or corrections like this many, many times in the past and we’re going to receive them many, many times in the future too. This is a natural part of investing.

If, however, you’ve got more than 7 years before you need your capital then use this as a buying opportunity, a chance to steadily rebalance your portfolio – buying more equities and investing more. I use the word steadily because we don’t know where the bottom is; the market could stabilise and then carry on growing, or it might correct further, and you’d wish you’d bought in lower.

If you have an investment plan which generally focuses on pound cost averaging – investing in the stock market monthly over a period of time – stick to it. Don’t deviate. Fundamentally, economically nothing has changed other than the economy is growing. We have a fear of rising interest rates, that’s what’s spooking the market.

Savers

Next you have savers, who want rising interest rates. We will eventually see the effect of rising interest rates, but remember, they haven’t increased yet; it’s just the threat of an increase. If you’re looking to save some money for a period of time, then you’re probably better off using shorter-term interest rates than longer-term, because we are most likely going to see rates rise. It wouldn’t be unreasonable to see them rise towards the 3% mark, which is about average over time. Savers should continue to save money, but don’t tie it up for too long so that you may get better deals as rates rise.

Property owners

Property owners are either looking at capital appreciation or concerned about mortgage rates.

If you’re looking at capital appreciation, it’s important to understand with property you really have is a fixed income investment: an asset that yields a fixed income (albeit rising with inflation typically). What generally happens with fixed income investments when interest rates rise is that the capital value goes down; with property it’s because you can get a better yield on deposit or the property, when using a mortgage, costs more in interest. So what you might see is a plateau in property prices, or even a slight decline in them eventually. We’ve already seen this in London, where some areas are down around 25% from their highs… but the London market is or was overly inflated because of foreign money supply; extremely wealthy overseas investors bought London property just wanting a ‘home’ to park their savings!

Property owners don’t necessarily need to fear interest rate rises. If you live in your home and don’t plan to sell, it doesn’t matter what it’s worth now (and if it comes down you may pay less inheritance tax). What you do need to watch out for is buying now at a high loan-to-property value – be careful not to overexpose yourself to interest rate changes in the future. At all times, make sure you can afford repayments at the rate today, and the potentially higher rate in the future. Lenders will often ‘stress test’ your mortgage, checking affordability at a higher interest rate, but you should do this for yourself.  Look at your budget and see if you could afford a higher payment of say 25%.

These rate rises have been expected for a number of years, it would be unhealthy to stay at historic lows around 0.25% – 0.5% forever, it’s not healthy for the economy for rates to rise. When you look at bank base rates and mortgage rates, they’re likely to have factored in a probable upturn in rates already, so don’t necessarily expect to suddenly get a fantastic deal.

If you’re concerned about the prospect of rising rates, speak to your lender and see what fixed rates are available.

What about people who don’t fall into any of those categories, does it affect us all?

In isolation, one correction (especially if you’re not investing) won’t really impact you. If you’re not investing, I’d ask why not of course! But there are a couple of ways the markets affect almost everyone.

You’re likely auto-enrolled in your employer’s pension scheme, so you are in effect invested in the market, you’re just likely not engaged in it. You can get more involved, talk to the provider and find out where your money’s invested.

Secondly, what we might start seeing is wage inflation. There’s been a lot of talk about wage stagnation for many years and that’s because inflation’s been so low for so many years. We’re now seeing inflation pick up, and interest rates following suit, and when you see that you should naturally expect prices to rise, and wages to rise too.

These are natural, healthy things for an economy: we’re going back more towards more the mean and average of what we’d expect. Unfortunately the media can sensationalise things and start talking about market crashes, scaring people, but it’s all perfectly normal.

If you’re not an investor, it’s a great time to consider becoming one now – but only if you’ve got 5-7 years to invest. If you’re saving for a house in a few years, then it’s not the place to be. You really need to make sure you’re putting money into the stock market with a long-term plan.

What you need to do is look at your compelling vision, what it is you want to achieve. Once you’re financially well organised and got your House of Wealth in order and repaid any unsecured debt, then it’s time to invest. Just don’t worry too much about sensational headlines when you do – stick to your long-term plan and you’ll enjoy a better experience.

 
Volatile markets and a sunny economy
Interview between Paul and Warren about the recent stock market volitiltiy

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