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Last week, central banks around the world saw a flurry of interest rates.
On May 4th, the US Federal Reserve voted to raise interest rates by 0.5%, which will move its key interest rates to a range of 0.75% to 1%.
Meanwhile, in London on May 5, the Bank of England shared the same sentiment.
Its monetary policy committee voted to raise official interest rates by 0.25%, taking the UK benchmark to 1% from 0.75%.
Minutes are not yet available to determine whether that vote was unanimous or a majority decision, but this marks the fourth consecutive rise in UK interest rates in the committee’s last four meetings, indicating MPC members remain on the same page .
Financial markets have seen volatile trading sessions as investors process these events.
On Wednesday, the S&P 500 rose 3% in 24 hours on news of the US decision.
On Thursday, the FTSE 100 index closed at its opening level after initially climbing 1.5% by midday.
Given these policy changes, what is the outlook for stock market investors and what can we expect from our stock portfolios over the coming year as a new economic reality of high inflation and rising interest rates takes hold?
This article offers analysis from different angles.
The positive outlook:
In many respects, higher interest rates point to a return to normalcy for the financial markets.
Since the financial crisis of 2008-20211, a monetary curse has been placed on the developed economies.
Central banks cut interest rates to historic lows in the wake of the financial crisis and the ensuing recession, but in the years of recovery that followed, they were unable to raise rates without pushing their economies into recession.
This fragile situation resulted in interest rates in many economies such as the US, Canada and the UK being at or near zero, and German interest rates even going negative.
This deprived central bankers of their main stimulus tool, the rate cut, as rates could not be lowered any further.
Instead, they resorted to a new technique known as “quantitative easing,” which involved buying large amounts of assets that otherwise helped support prices.
The positive outlook of the current hikes (and many more hikes to come) is that the bank will now have significant leeway to cut interest rates as needed to stimulate the economy, which should help the UK weather a serious recession in the near future to avoid.
These recessions tend to pose a significant threat to investors buying stocks through stockbrokers like DEGIRO, as stock markets suffer downside shocks when economic indicators fall.
UK investors with heavy exposure to foreign companies will also benefit from a weakened pound.
Britain’s economic outlook was bleaker than the Fed’s, causing the pound to fall to a two-year low against the US dollar on Thursday.
This increases the GBP value of all investments denominated in a foreign currency.
The negative outlook
On the bearish front, stagflation is becoming a reality. Stagflation is the combination of low (or negative) growth with high inflation, resulting in negative growth in real terms.
Stagnation is a rare phenomenon that has been most closely associated with the Japanese economy since the 1990s.
Stagnation can lead to a reduction in living standards and is therefore something central bankers and governments want to avoid at all costs.
Stagflation is unusual because the main cause of inflation is usually an overheated economy.
By this we mean an economy that is stretching its natural capacity to produce goods and services.
When an economy is tight, labor shortages drive up wages and commodity prices rise as consumers and businesses compete for the products they want.
However, this is acceptable in the context of a booming economy, as both workers and government experience rising incomes that can be used to pay higher prices.
In a stagflationary environment, products and services rise in price and fall in affordability.
The poorest suffer most as the prices of basic foods and services become too expensive and deprivation sets in.
Government finances will be tight because while tax revenues may rise in nominal terms (due to higher prices and wages), the real purchasing power of those tax revenues will fall, meaning the Chancellor will have fewer resources to redistribute the economy.
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