The US Federal Reserve’s decision to increase its key lending rate by 0.25% to 0.50% marks the end of a momentous era in monetary history. The move has brought to an end a six-year period of record-low interests rates and has been heralded by many as the start of a new era for the global economy.
Only time will tell if the Fed’s decision to hike interest rates was the right thing to do but for today, markets around the world are in a euphoric mode. At time of writing, the FTSE 100 is up over 1%, following similar moves by Asian and other European markets, although it’s unlikely that this rally will last for long.
Diverse index
As I’ve written many times before, the FTSE 100 is a truly global index. More than two-thirds of the index’s profits come from overseas and as a result, the FTSE 100 is highly sensitive to global economic trends. What’s more, over the past 12 months the FTSE 100 has undergone a huge transformation.
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Indeed, at the beginning of the year miners made up a large percentage of the index. But after a year of bad news from the mining sector, they now make up only 4%. British American Tobacco and Imperial Tobacco currently account for 7% of the index and HSBC, Lloyds and Barclays make up more than 12%.
It’s unlikely that miners will stage a comeback even with higher interest rates. At time of writing, all key commodities are down today, even as other markets rally. Oil, copper, silver, gold and iron ore are all falling today, which is only going to make it harder for miners, especially with interest rates going up. Miners such as Glencore and Anglo American are overloaded with debt and higher interest costs will only squeeze margins further.
Good news for financials
While higher interest rates will be bad news for some of the FTSE 100’s constituents, it will be good news for others: specifically, financial services firms.
They now make up more than 21% of the FTSE 100, so the index is heavily weighted to the sector. Banks in particular, make up around 14% of the index. These should be the main beneficiaries of rising interest rates and it’s all to do with the net interest margin.
Put simply, the net interest margin is a measure of the difference between the interest income generated by banks and the amount of interest paid out to borrowers, relative to the amount of their interest-earning assets. However, the percentage of interest paid out and received by the banks is linked to central bank interest rates. As central bank rates push higher, the net interest rate earned by banks will widen. As an example, analysts at Citigroup believe that a 0.06% increase in Lloyds’ net interest margin will boost the bank’s earnings per share by 5%. That’s a huge improvement for such a small increase the Fed having just increased rates by 0.25%.
The bottom line
Overall, financial services firms will be the main beneficiaries of the Fed’s interest rate hike and the FTSE 100 will benefit as a result. That said, even with the financial sector doing all the heavy lifting, the index is unlikely to return to 7,000 anytime soon.
