How do rising interest rates affect equity markets?

If you read, listen, or watch any form of news media in mid-2022, it’s hard to conceal away from numerous macro-economic variables being plastered in your face. Today, I’m here to examine how changes in interest rates affect equity markets.

The current state of play

Last week, the Federal Reserve lifted the official interest rate by 0.75 percentage points, the biggest increase in 28 years, as it intensifies efforts to combat the highest US inflation in four decades.  Its latest move takes the Fed’s key interest rate target range to 1.5% to 1.75%. US annual inflation stands at 8.6%.

Last week, the Reserve Bank of Australia increased the official interest rate by 50 basis points to 0.85%, the biggest single rise in 22 years. Australia’s annual inflation rate currently sits at 5.1%.

Most people know the interest rate as the amount banks charge borrowers on a loan or the rates you earn on your savings accounts. However, interest rates are much deeper than the retail rates used by banks. These rates flow rich in how financial intermediaries transact and form the base on which the structure of interest rates in the economy is built.

Why are interest rates rising?

During the pandemic, central banks around the world lowered rates to encourage consumer spending and credit growth in hopes of stimulating the economy.

Fast forward to 2022 with supply bottlenecks from a pandemic and war in Ukraine, along with households venturing out from lockdowns and spending stimulus payments, and you’ve got “skyrocketing” inflation.

Central banks are now signaling an extension of a tighter monetary policy cycle (rising rates) with hopes to cool a very hot economy and rampant inflation. The outlook from both reserve banks is very similar, they will continue to raise rates until they see signs of the broader economy contracting.

Relationship between rates and equities

As interest rates rise, the cost for companies to borrow money increases. Every dollar companies use to service debt is a dollar that will not be counted in net profits and a dollar that won’t be paid out to shareholders in dividends.

Businesses with stronger balance sheets can typically fund their operations from existing cash flows, and therefore, have less need for debt. Whereas companies with higher debt profiles typically have lower returns on capital, and consequently, have inadequate cash flow to support their operations. This can be exacerbated by rising inflation, which could see a rise in funding costs, leases, wages etc.

How does these affect valuations?

The process of determining the fair value of a stock is called valuation. Basically, a stock’s valuation is equal to its estimated future cash flows.

Typically, when interest rates are low, future profits are valued more highly. Conversely, when rates rise, promises of future profits become less valuable.

The relationship between interest rates and future profits weighs most heavily on new and growing companies where most profits are still years away. This is likely due to companies making a loss to chase growth of future profits. Therefore, valuations are heavily impacted as their cash flows don’t exist until further in the time horizon. We are seeing this play out in the current market, growth and many technology stocks prices have been hit due to the long duration of their earnings.

Rates increasing also affect consumers behaviour – as rates increase to curb inflation and the rising cost-of-living, consumers become pessimistic about the future. This tends to shift spending habits from dining out to managing their mortgage. In this environment, you’ll typically see the consumer discretionary sector decline, while the consumer staple increases.

It’s not all bad news, rising interest rates do not affect all companies equally, in fact, some sectors benefit from higher interest rates such as the financial sector. If you are in the business of leading money, higher rates mean higher margins. That’s why it’s important to have a well-diversified portfolio, spread across multiple asset classes and sectors to benefit from each of their features. At Hewison’s we endeavour to build four season portfolios, whereby short-term fluctuations in markets are opportunities. We ignore the noise and invest in quality companies for the long term. There will always be short-term fluctuations, the reality is the odds are stacked heavily in your favour if you invest for the long term, regardless of the market cycle (or interest rate).