On 11 March, the Bank of England (BoE) cut the main interest rate from 0.75% to 0.25%. As I write, broader markets in the UK are (at least initially) taking a pause from their recent falls. And investors are wondering what this development may mean for their portfolios. Therefore, I’d like to discuss the potential effect of BoE’s interest rate decision on the FTSE 100 index.
Low interest rates are here to stay
Even before coronavirus-related headlines hit the newswires, policymakers had noted they expected interest rates to stay at low levels for many years to come.
Interest rate decisions affect the cost of mortgages, credit cards and other borrowings for both individuals and businesses. Typically, lower interest rates are considered good news for stock markets. In other words, there’s an inverse relationship.
For example, legendary investor Warren Buffett firmly believes stocks outperform all other asset classes over the long term. Especially if interest rates and corporate tax rates remain low.
Rate cuts aim to add stimulus to our economy. They usually trigger mortgage, car and personal loan rates to fall. They make it cheaper for consumers to borrow money.
British businesses may also find it easier to fund new investments. Many companies like utilities, such as National Grid and SSE, and telecoms firms, such as Vodafone or BT Group, tend to carry high levels of debt on their balance sheets. Therefore, lower rates may mean a boost to their bottom lines.
How about the pound?
When the BoE cuts rates, the pound is usually devalued against other major currencies, such as the US dollar or the euro.
Most FTSE 100 companies are multinational conglomerates. Up to three-quarters of their revenue comes from overseas. When interest rates decrease and a devaluation of the pound against, for example, the US dollar occurs, this may impact UK businesses that generate income in dollars. The dollars they’re earning outside the UK now become worth more pounds. This, in turn, leads to a potential increase in profitability.
For US consumers, British goods would also become less expensive. Thus, UK exports may increase overall. That said, a weaker pound makes imported raw materials more expensive. And the increased costs eventually get passed down to the consumer.
However, other central banks globally have also been cutting interest rates in recent days. Therefore, the overall effect on the value of the pound may not be so clear cut.
FTSE 100 shares with the highest non-UK revenue come from various industries. They include miners, industrials, oil companies and pharmaceuticals. Fresnillo, Rio Tinto, BHP Billiton, BP, AstraZeneca, GlaxoSmithKline, and Smith & Nephew are examples.
Foolish takeaway
Many established companies will normally hedge against currency risk. Yet earnings in the short-run may still be affected by exchange rate headwinds. However, any potential adverse effect may easily be offset by increased business opportunities offered by a lower interest rate environment in a given economy.
My strategy now? The current situation isn’t just an economic problem, it’s also an important human healthcare problem. I’d pay attention to what our health authorities advise but, at the same time, carry on investing in strong companies I believe in. I’d also watch out for short-term price dips to buy more.
