Financial markets were given a jolt on Thursday, after the Bank of England announced that it may raise interest rates “over the coming months.”
The bank is concerned that inflation is rising above its target rate of 2%, and while the nine member Monetary Policy Committee voted 7-2 to keep rates on hold for now, it advised:
“Some withdrawal of monetary stimulus is likely to be appropriate over the coming months in order to return inflation sustainably to target.”
The pound surged on the news, and many dividend paying ‘bond-proxy’ type stocks were sold off. Should dividend investors be worried? In my view, no.
Interest rates and the stock market
Textbooks will tell you that there’s an inverse relationship between interest rates and the stock market. If rates rise, stocks should fall. There’s several reasons for this.
For a start, as rates rise, borrowing costs increase, and company profitability should therefore decline, pushing down stock prices. (One exception to this rule is the financial sector. Banks can actually benefit from higher rates as it allows them to earn more from the spread between the capital they borrow and the capital they lend out.)
Furthermore, as risk-free interest rates rise, the yields on risky assets such as stocks should become less appealing.
It’s also worth considering that higher interest rates should push sterling up, therefore reducing the profits of the large FTSE 100 companies that generate earnings overseas.
Bond-proxies fall while banks rise
This pretty much explains what we saw on Thursday after the Bank of England’s announcement.
Many bond-proxy type stocks such as Unilever, Reckitt Benckiser and British American Tobacco were sold off, while shares in Lloyds Banking Group actually rose.
Should dividend investors be worried?
While it’s not ideal to see the share prices of companies you own fall, the key, in my opinion is to view share price weakness as an opportunity.
Many high-quality dividend stocks have been trading at relatively high valuations for a while now, so any share price weakness may present good opportunities to buy quality companies at lower prices, with higher dividend yields.
Realistically, any interest rate rise is likely to be very small. It’s highly unlikely, in my opinion, that the bank would raise rates significantly with the economic uncertainty that is lingering as a result of the UK’s decision to leave the European Union. The returns on offer from savings accounts are still likely to be very poor, meaning that a portfolio of high-quality dividend stocks should easily outperform cash over the long term.
A look at past history
It’s also worth looking back to 2006-2007, to see how the FTSE 100 performed when the Bank of England last raised interest rates. It’s a long time ago now, but rates were raised four times, from 4.75% to 5.75% between August 2006 and July 2007.
How did the FTSE 100 perform in this time? The index actually rose from around 5,900 points to 6,700 points. With that in mind, I don’t think dividend investors should be too concerned about a possible rate rise for now.
Disclosure: Edward Sheldon, CFA has no position in any shares mentioned.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.