Investors fear equities will suffer a relapse

Simon Hildrey asks if the higher cost of borrowing will stall the comeback on the stock market

An interest rate rise might not only upset homeowners, it could spell bad news for investors by reining in the recent tentative recovery in the stock market.

Over the past few months, consumer spending has rocketed, fuelled by the Monetary Policy Committee's previous decision to keep interest rates on hold at 3.5 per cent. And while last week's rise to 3.75 per cent may not be substantial in itself, investors are likely to see it as a signal that the trend for falling rates has come to an end. Instead, the cost of borrowing will probably move upwards in the coming months.

Not only that, but US interest rates could have an effect. Tim Price, senior investment analyst at wealth management firm Ansbacher, believes that if the Federal Reserve raises rates, it could be "catastrophic" for UK equities.

Mike Lenhoff, chief strategist and head of research at stockbroker Brewin Dolphin, believes that a rise in UK rates could be significant for stock markets as it would signal a change in monetary policy.

"Markets react strongly when there is a break in the cycle," he says. "It will still be possible to make money from equities but a rate rise means it will take more effort than over the past seven months. This is even though the rate rise will, I believe, be counteracted by positive corporate newsflow.

"A quarter point rise in rates is not important by itself," he adds. "But it signals that the easing phase of monetary policy has come to an end. It tells the market that central banks around the world will start tightening their policies."

Mr Lenhoff cites the example of 1994 when the Federal Reserve raised rates by just 0.25 per cent. Even though the rise was widely expected, both bond and equity values dipped. "British equities fell 10 per cent that year," he says.

While Mr Lenhoff believes good corporate news will partly offset the rate rise, he also thinks that investors will shift away from small caps and cyclical stocks to large caps which "offer better value and are more liquid". This is a view shared by fund managers after the outperformance this year of small and mid caps.

Richard Hughes, manager of the M&G Dividend fund, argues that if the Bank of England increases rates by only 0.25 per cent - as a "warning shot for consumers" not to carry on borrowing at current rates - then the market will not react negatively.

But Mr Hughes agrees with Mr Lenhoff that there will be a slow drift out of small and mid caps, which "are more sensitive to moves in interest rates". He also expects defensive stocks to come back into favour as monetary policy tightens.

"Obviously banks have a large exposure to the mortgage market, but there is no sign of trouble there," he says. "I also expect oil stocks to come back into favour. BP and Shell are still yielding just short of 4 per cent."

Although he points out that the rate rise had been flagged in advance, and thinks "a 0.25 per cent increase will not have a material impact on consumers", Anthony Cross, manager of the Liontrust Intellectual Capital Trust, believes the market will react negatively at first. "Housebuilders and retailers will be among those hit most by a rate rise," he says. "I would expect the mid-250 to fall in the short term as it is a less liquid part of the market. But then things will settle down again."

"Some stocks do well when rates rise, such as credit firms," he adds. "Investors should look for companies that can increase their rates of interest to clients higher than the Bank of England.

If rates do go up over several months, Mr Cross thinks income funds may become less attractive to investors because they might be able to gain a better yield on a savings account with no risk to their capital.

While fund managers are generally optimistic about the UK economy, despite the Treasury's difficult task of balancing high consumer spending and house price inflation with a depressed manufacturing sector, problems could come in the medium term and from the US.

Ansbacher's Mr Price says: "I would not expect much impact on UK equities from a rate rise and I do not think the US Federal Reserve will increase rates for another six months. But if it did, it would be catastrophic.

"The problem will come from the high level of debt of both the consumer and government in the UK and US. Taxes in the UK will have to rise to pay for the large budget deficit, which may come through stamp duty and national insurance. The US budget deficit is spiralling out of control, which is a key problem for the global economy."