Investors cannot afford to ignore the influence of interest rates on markets says Vincent McEntegart – Investment Manager at Aegon Asset Management. In this article, he explores how higher bond yields are reshaping the investment landscape and raising the bar for equity returns.
September was the month central banks took a hike. The 0.25% interest-rate increases announced by the ECB and the Federal Reserve reflected a broader global shift toward tighter monetary policy, as policymakers sought to slow demand and bring inflation back under control.
The Bank of England chose not to raise rates, maintaining its view – by a 6-3 majority at September’s MPC meeting – that a base rate of 3.75% is sufficient to contain inflationary pressure.
That followed a steady easing cycle from the post-pandemic peak of 5.25%, with the base rate lowered to 5% in August 2024 and cut five further times over the following sixteen months.
Even so, the MPC has left the door open to another hike before year end. Markets are pricing in as many as four increases by the end of July 2027, which would take base rate to 4.75%.
That would be good news for savers, but less welcome for households needing to refinance mortgages. Market pricing can be wrong, but it highlights current concerns that forces outside policymakers’ control are putting renewed upward pressure on inflation.
Energy and food prices remain central to that concern. With oil well above $100 a barrel and gas prices also elevated, UK household energy bills could rise by 25% in January when the price cap resets.
The summer drought has already pushed food prices higher, and further pressure is possible if Super El Niño disrupts agricultural production across key southern hemisphere regions.
Higher interest rates matter for equity markets because they affect both the price investors are willing to pay for future profits and the level of profits companies can generate.
At the simplest level, an equity is worth the present value of the cash flows a company is expected to produce over time. When rates rise, the discount rate applied to those cash flows rises as well.
All else equal, that reduces the present value of future earnings and puts downward pressure on share prices.
This effect is most acute for long-duration equities, such as high-growth technology companies. These businesses are often valued on profits expected many years into the future.
When rates rise, those distant profits are discounted more heavily, so valuations can fall sharply even if the operating outlook has not changed significantly.
Companies with more immediate cash flows, lower valuation multiples and stronger current earnings tend to be less exposed to this discount-rate effect.
Higher central bank rates impact government bond yield curves, often pushing up longer dated bond yields. These higher yields create direct competition for equities, with the 10-year government bond yield acting as the most visible reference point.
Yields are already high by post-financial-crisis standards: around 5% in the US, 3% in Japan, 3.5% in Germany and 5.3% in the UK. At these levels, government bonds and investment-grade credit offer a meaningful alternative to equities, raising the hurdle rate for owning shares and reducing appetite for highly valued or speculative companies.
The earnings channel is just as important. Higher rates increase borrowing costs, particularly for companies with floating-rate debt or near-term refinancing needs. Rising interest expense can reduce net income and free cash flow, while more expensive mortgages, car finance, credit cards and business loans can slow consumer spending.
Sectors linked to housing, discretionary consumption and capital investment may therefore face weaker demand. If growth slows materially, equity markets can be hit by both lower valuations and weaker earnings expectations.
That said, the relationship between rates and equities is not mechanically negative. The reason rates are rising matters. Central banks are hiking and yields rising alongside stronger growth and improving corporate earnings, allowing equity markets to perform well.
Earnings growth is offsetting valuation pressure, especially for companies with pricing power, low leverage and resilient margins. But inflation is proving sticky and the need for hikes to slow down demand increases the risk that equities may struggle from here.
Sector performance can diverge meaningfully in a higher-rate environment. Banks and some insurers may benefit from improved returns on assets and wider net interest margins, although credit losses may rise if the economy weakens.
Energy, materials and other cyclical sectors can perform well when higher rates coincide with robust nominal growth. Defensive sectors such as healthcare, consumer staples and utilities may attract investors seeking stability, though utilities and infrastructure can remain sensitive to bond yields because of their debt levels and income-like characteristics.
For investors, the central implication is that higher 10-year yields raise the hurdle rate for equity ownership. Companies must justify their valuations through stronger earnings growth, better cash conversion or more reliable capital returns.
Balance-sheet quality becomes more important, and markets are likely to punish businesses that depend heavily on cheap financing. Portfolio leadership often shifts away from speculative growth and toward quality, value and income.
Equity markets have coped with higher yields so far this year, but the margin for error has narrowed.
The concern is not that today’s yield levels automatically make equities unattractive; it is that yields are now close to the point where valuation pressure, refinancing costs and weaker demand become harder for markets to absorb.
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