If a stock market crash happens tomorrow, major market indices will see billions wiped off their value.
It’s a scenario that keeps many investors awake a night, especially with 2022 now considered the ‘year of rising interest rates’ following the Bank of England’s latest decision to up its base rate from 0.25% to 0.50%.
So, will higher interest rates cause the stock market to tumble? Let’s take a look.
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What is a stock market crash?
A stock market crash generally refers to a sudden double-digit percentage drop in stock values.
When the stock market crashes, it almost always takes investors and the government by surprise. That’s because unexpected events are often the cause. The 2020 stock market crash is a good example of this. Stock prices tumbled as soon as investors began to realise that Covid-19 posed a serious threat to the global economy.
Stock market crashes may also be caused by sentiment, usually when investors ‘wake up’ to the fact that stock prices may be inflated. This can cause a domino effect, whereby investors who dump their stocks unwittingly persuade others to do the same. The infamous 2001 dotcom bubble burst was an example of herd behaviour in action, which ultimately triggered a mild recession.
Any investors who’ve experienced a crash will know all too well that such events can be financially devastating. So, in our current environment of rising inflation and higher interest rates, is the next stock market crash just around the corner?
To answer this question, let’s first explore the correlation between rising interest rates and stock prices.
What’s the deal with inflation and higher interest rates?
Right now, the global economy is experiencing high levels of inflation. In the United States, inflation is running at 7.5%. In Germany, it’s 4.9%, while in the UK, the latest ONS figures have revealed that inflation is running at 5.5%.
When inflation begins to spiral, central banks typically step in to raise borrowing costs. In the UK, the Bank of England raised interest rates from 0.25% to 0.5% in January and further rises are expected.
Meanwhile, the US Federal Reserve faces huge pressure to raise interest rates and is expected to act soon. This is important, as interest rates in the US hugely influence the global economy.
How can rising interest rates impact share prices?
Higher interest rates, by definition, make borrowing costs more expensive. This means businesses typically face higher costs to invest in new products or services. This can limit growth and, consequently, harm profits. As a result, share prices can be negatively impacted.
Don’t forget that higher borrowing costs impact consumers too, leading to a reduction in disposable incomes. When this happens, there’s typically a reduction in consumer spending, harming businesses further. Again, this can have a downward impact on stock prices.
Of course, a reduction in stock values doesn’t necessarily lead to a stock market crash. However, if stock prices begin to plummet across the board, then the market’s sentiment can change very quickly.
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Should investors worry about a stock market crash?
If you have lots of assets in the stock market, then a stock market crash will obviously be unwelcome. Yet, some investors may actually consider a stock market crash as an opportunity to buy stocks at ‘discount’ prices.
Whatever your view, it’s important to note that market crashes have happened before and will almost certainly happen again. Whether the next one will happen next week, later this year, or in five years’ time, nobody truly knows.
If you’re concerned about the possible impact of a stock market crash, then it’s worth assessing your portfolio to ensure it aligns with your risk tolerance. For example, you may be a few months away from retirement and planning to rely on your investing income. If so, your risk tolerance will be lower than that of a younger investor looking to increase their wealth over several decades.
If you’re unsure about your attitude to investing, take The Motley Fool’s risk tolerance quiz.
Are you looking to invest? Take a look at our list of top-rated share dealing accounts to ensure you don’t overpay on fees. If you’re new to investing, it’s a good idea to read our investing basics to get you started.
The post Will rising interest rates cause a stock market crash? appeared first on The Motley Fool UK.
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