Could rising interest rates trigger a stock market crash?

City traders are betting that the Bank of England will increase interest rates before Christmas, in an effort to tame surging inflation. Could this trigger the next stock market crash?

We already know that many businesses are facing problems due to higher costs. Soaring energy prices are causing havoc for consumers and industrial customers. Supply chain problems and the global chip shortage are holding back car production. Lorry driver shortages have led to food shortages in UK shops.

Higher interest rates could push up the cost of debt for businesses and consumers, triggering a crash. On the other hand, prompt action by the Bank of England could help to bring other costs — especially energy — down to more normal levels. The situation is delicately balanced. Here’s what I think could happen next.

Why higher interest rates could cause a stock market crash

There’s no fixed relationship between the stock market and interest rates. But there are some common patterns. When interest rates rise, consumer and business spending tends to fall.

Higher interest rates make borrowing money more expensive. They also mean that savers can earn more by keeping cash in their accounts.

When consumer and business spending falls, economic activity tends to slow too. For this reason, rising interest rates are often linked to a falling stock market.

What about inflation?

Of course, rising costs can also cause economic activity to slow. UK inflation is currently running at 3%, the highest level seen since 2008. Some estimates suggest inflation could peak at 6% over the next 12 months.

Here in the UK, we’ve already seen some big industrial companies cut back on gas use in the face of rising costs. More cutbacks could be needed this winter if the UK runs short of gas.

There are problems in other areas, too. Companies have been absorbing some rising costs, such as shipping, labour, and other raw materials. But if costs stay high, businesses will have to increase their prices or see their profits collapse.

Higher prices mean that consumers and businesses might start to delay their spending plans. That could lead to a slump in economic activity — and potentially a stock market crash.

Is it too late to buy shares?

Are things really as bad as I’m suggesting? There’s no way to be completely sure. Over the last 18 months, normal patterns of supply and demand in the economy have been badly disrupted.

Returning to normal, balanced levels of activity was always going to be difficult. It may just be that we’ll need a few more months for things to settle down. 

In any case, I’m not too worried about the risk of interest rate rises. The Bank of England rate is currently just 0.1% — an all-time low. A rate rise to 0.25% is being rumoured in December. That’s still very low by historic standards and is well below the pre-pandemic level of 0.75%. I don’t think it would be enough to trigger a stock market crash.

Fear of a stock market crash is certainly not stopping me from buying shares. Indeed, I think the sell-off we’ve seen since September has created some interesting buying opportunities. In the remainder of this article, I’m going to look at three UK shares that are on my buy list at the moment.

UK shares: what I’m looking for

As a long-term investor, my aim is always to find good quality companies at reasonable prices. I want to hold my shares for years, so I need them to be able to deliver steady growth and rising dividends.

I don’t want to worry about whether the companies I’m invested in are likely to go bust. To minimise this risk, I avoid companies that are loss-making or have too much debt.

Right now, I also have another requirement in mind. I think there’s a risk that the global economy could slow next year, so I’m looking for businesses with defensive characteristics.

A consumer stock I’d buy in a market crash

One UK share I’d buy today is Tesco (LSE: TSCO). As the UK’s largest supermarket, Tesco has great buying power and serious economies of scale. I reckon Tesco will find it easier to handle rising costs than its smaller rivals.

I’m also encouraged by this retailer’s continued growth. Sales rose by 3% to £27,331m during the first half of this year. Tesco’s operating profit rose by 30% to £1,304m during the six-month period, as pandemic costs faded away.

The main risks I can see are that Tesco could start to diversify or make acquisitions overseas in the hunt for new growth. Last time this was tried, it ended badly.

Fortunately, I think that’s unlikely under current management. CEO Ken Murphy has made it clear that he’s focused on generating shareholder returns from the core UK business.

With Tesco stock trading on 13 times earnings and offering a market-beating 3.7% dividend yield, I’d be happy to buy today.

20 years of dividend growth

Another FTSE 100 stock I’d buy in this uncertain market is defence group BAE Systems (LSE: BA). The group’s long-term focus and diverse mix of defence businesses should mean that it’s able to ride out short-term issues without too much difficulty.

This business hasn’t cut its dividend for more than 20 years and was largely unaffected by the events of last year. Although BAE does have a rather large pension deficit, rising interest rates could help here. The complexities of pension accounting generally mean that liabilities fall when rates rise.

Defence stocks aren’t everyone’s cup of tea. But I’ve followed BAE for years and it’s been a reliable performer. With a tempting 4.2% dividend yield, I see this as a defensive buy today.

A tech growth story

My final pick is technology stock Computacenter (LSE: CCC). This FTSE 250 company provides IT solutions for corporate and public sector clients. Sales exploded last year as millions of people needed to start working at home.

Some customers may cut back on spending this year after last year’s upgrades. That could pressure on this year’s results, but I’m not worried. This business has a long track record of growth — sales and profits have doubled since 2015.

I rate management highly here, too. CEO Mike Norris is the longest-serving boss in the FTSE 250. He’s already led the company successfully through some difficult times.

Computacenter’s share price has slipped back recently, leaving the stock on 17 times forecast earnings, with a 2.3% yield. I’m tempted to buy at this level.