Interest rates have increased rapidly since February 2022, from a near-record low of 0.5% to 4% today. But why are interest rates increasing? The short answer is to counter inflation. Tom Joy, Corporate Finance Senior Manager at PKF Smith Cooper, explains more in our latest ‘5 minutes with Corporate Finance’ article.
The conflict in Ukraine and pandemic-related supply shortages have contributed to inflation hitting double-digits (10.5% in December 2022, ONS), with both businesses and consumers impacted – some more than others. For example, businesses in the food and drink sector have experienced food inflation of 16.8% (between December 2021 and December 2022, statista).
As a result, the Bank of England (BoE) has increased interest rates in an attempt to stabilise the inflation rate back to the UK target of 2%.
In theory, increased borrowing costs limit business expansion. Individuals are also inclined to make the most of favourable saving rates (or risk experiencing increased personal borrowing), which can cause a decline in consumer spending. This causes the demand for goods and services to fall, resulting in lower prices and reduced inflation.
Once inflation reaches or falls below the 2% target, the BoE can reduce interest rates again to attract more investment and growth.
How do higher interest rates affect businesses?
The impact of rising interest rates tends to result in companies cutting back on investment, as demonstrated by UK business investment falling by 2.5% in 2022 Q3 (ONS).
Rapid increases in interest rates usually stagnate economic growth or lead to a possible recession, as is now forecast. Such periods historically resulted in consumer spending decreasing along with investment and stock market valuations being reduced.
However, it is not all doom and gloom, as some sectors are affected less than others. Certain ‘recession-proof’ sectors tend to perform well in downturns, including three of PKF Smith Cooper’s specialist sectors: Food & Drink, Franchise and Fire & Security.
In the Fast-Food Franchise sector, despite high inflationary costs and selling price increases, consumer demand has persisted. Revenue is forecast to increase by 2.8% p.a., the number of distinct brands is forecast to increase by 2.2% p.a. and employee numbers are expected to grow by 0.5% between 2022-2027, contributing to future economic growth (PKFSC).
The Fire & Security sector provides ‘maintenance’ services that are required in all economic conditions. That market is forecast to expand by 29% from £1.4bn to £1.8bn by 2025 (PKFSC), indicating that the industry will remain resilient during these turbulent times.
The outlook for interest rates
More rate increases are likely, but most analysts believe that these may peak by the middle of 2023 and will begin to fall by the end of the year. The BoE would not want to impair economic growth in its efforts to achieve its inflationary goal of 2%, and further interest rate increases may force the economy into a deeper recession.
Recession is defined as negative growth for two consecutive quarters. It is now expected that the recession in 2023 will be short in duration (Gov UK).
Analysts believe that interest rates will peak between 4.25% and 4.75% (The Guardian) – lower than previously forecast during the era of Liz Truss’ leadership and her Mini Budget.
The next meeting of BoE’s monetary policy committee to discuss interest rates will be held on Thursday 23rd March.
The M&A market outlook
At PKF, we have a strong pipeline of engagements in a variety of sectors, and our view is that M&A activity in 2023 will remain robust.
Whilst M&A activity may feel the pressures of more ‘expensive’ debt, there are still many acquirers with ‘dry powder’ looking to acquire businesses.
The economic expectations have changed from a ‘strong recession’ to a ‘mild recession’, reinforcing business confidence.
Additionally, increased cross-border M&A activity is expected in the UK due to favourable exchange rates. In particular, the pound remains weak against the dollar and US analysts have lowered the probability of a recession in the US, suggesting US businesses will play a part in the UK M&A market.
To conclude, we do not expect the M&A market for UK SMEs and recession-proof businesses to be severely impacted by the higher interest rates, although larger companies may feel the pressure as they find themselves forced to make strategic changes and restructure to balance cash-flow as debt payments continue to rise.