The Bank of England has raised interest rates for the first time in a decade – but what does this mean for investors?
The official interest rate is back to where it was before the Brexit referendum in June last year with a hike from the record low of 0.25% to 0.5%.
For many in their thirties, this is the first time they have seen an interest rate rise in their investing lifetime and they will be wondering what to do next.
The main message is don’t panic.
An interest rate rise is not the end of the world and is not a signal the markets are about to tumble.
But the one lesson investors have learned since the financial crisis of a decade ago is that the economy, banks and their finances are inter-connected and a change in one often triggers a check-and-balance change elsewhere.
Bonds have seen a surge in popularity when government gilts have yielded a 1% return with such meagre returns from savings paid by banks.
But if rates are to ratchet up, they do not look so attractive and when inflation is factored in to the equation.
If the market sees a surge in sales, the price will likely fall, pushing up yields for buyers willing to take a risk.
Cash v equities
The rise in interest rates is not likely to offer an attractive alternative to investors while stock markets are continuing their upward push. Even if a bank passes on the entire 0.25% increase, the return is still negative when inflation of 3% is considered.
Another fall in the value of the pound will see earnings go up for FTSE companies as they generate most of their income overseas.
The struggling pound is the major factor that has influenced the FTSE since the Brexit vote and is likely to continue to do so although no one can predict what may happen after Britain breaks with the EU in March 2019.
Investing in businesses
Britain has some of the leading tax breaks for investors, with the Seed Enterprise Investment Scheme (SEIS) leading the way.
SEIS offers 50% tax relief on a stake of up to £100,000 in a start-up company, while the Enterprise Investment scheme (EIS) and venture capital trusts (VCT) are also popular with investors, even though their returns are lower.
These are options worth exploring for big earners who have maxed out their annual allowance for putting money into pensions as investing does not count towards the £1 million lifetime allowance or yearly pension contributions.
What does the rate rise mean for Britain?
Some analysts feel the Bank raised rates for the wrong reasons. Typically, a hike is a central bank tool that takes the inflation heat out of an economy.
But the British economy is not really racing ahead, and all the rise accomplishes is resetting the rate to pre-Brexit levels.
Inflation is higher than the economy has experienced for a good while, but only a little higher than the target rate of between 2% and 2.5%.
The rise was well-telegraphed by Bank of England governor Mark Carney and failed to set off panic in the markets.
Moving to smaller cap companies
If the underlying thrust of the economy comes from a weak pound, then the argument is larger companies are likely to see their profits – and corresponding dividends – fall if sterling strengthens at Brexit.
Should that happen, the logical move for investors is towards FTSE 250 businesses that are less reliant on making money overseas.
Although the pound gained a little against the US dollar and euro after the hike, the gains were lost shortly after, giving little reason for investors to fear a long-term sterling rally and no need to revise their portfolio strategy for now.
What should investors do?
The rate rise does not give any cause for concern or any reason to change investment plans.
Sit tight, watch how sterling performs and how the markets react.
Carney suggests rates will rise again – but only to slowly increase to 2.5% or 3% at least a year after Brexit. That’s three years of adjustment and plenty of time to see how the economy and markets are likely to react.
Find out more about the rate rise
The Bank of England Monetary Policy Committee has published a detailed analysis explaining the reasons behind increasing the official interest rate