How do rising interest rates affect equity markets?

Rising interest rates – a phrase that has been whipped from the lips of Australian investors for the last decade. But the Reserve Bank of Australia is on a rate rise tear to combat record-high inflation and slow the pace of economic growth, following in the footsteps of Central Bank around the world.

Far from esoteric economic policy, interest rates have an enormous impact on company earnings and equity markets – as everyone participating in the US market has seen this year. Alongside rising rate expectations has come increased volatility and negative returns as investors price in rate rises, reassess growth expectations and refocus on the fundamentals.

Changes in interest rates can impact companies and equity market performance in several ways. As interest rates rise, debt servicing costs increase and squeeze profits. Valuations, especially for growth sectors like technology, can be battered by a jump in rates. Finally, higher rates curb inflation by slowing the economy, an important source of profit for companies.

Here we explain the impact of rising rates on equity markets. We also uncover the sectors best positioned to keep their heads above the rising water.

What are interest rates?

Most people know the interest rate as the amount banks charge borrowers on their loan. However, interest rates are much deeper than the retail rates used by banks.
Australia’s cash rate is set by the RBA on the Tuesday of every month and influences how banks set their rates.

As the RBA puts it, the cash rate is the "rate charged on overnight loans between financial intermediaries". Banks are not required to adhere to the cash rate, but the RBA rate has "a powerful influence on other interest rates" and "forms the base on which the structure of interest rates in the economy is built".

In Australia, the cash rate has been at rock bottom levels since the 2020 pandemic at 0.10%. Rates have been historically low since the 2008 global financial crisis as central banks try to stimulate consumer spending and growth.

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. However, record low rates over the last two years have caused demand to outpace already stressed supply resulting in soaring inflation.

Central banks are now signalling an extension of a tighter monetary policy cycle in efforts to combat rampant inflation.

The Reserve Bank joined compatriots in the US, New Zealand, Canada and the United Kingdom in raising rates earlier this month. Investors expect multiple additional rate hikes from central bankers this year.

Futures markets are currently pricing the cash rate to hit 2.65% by December 2021.

Relationship between rates and equities

As interest rates rise, the cost for companies to borrow money increases.

Whether companies borrow money from a bank in the form of a business loan or they sell fixed income products such as corporate bonds to bring in cash, rising rates mean everything costs more.

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 higher returns on capital can typically fund their operations from existing cash flows, and therefore have less need for debt. In contrast, debt-intensive companies typically have lower returns on capital, meaning they may have inadequate cash flow to support their operations. This can be exacerbated by rising inflation, which could see rises in funding costs, leases, wages etc.

If you want to see if a company is in a good position to service debt, there are a variety of financial ratios which can come in handy, for example, the interest-coverage ratio.

This ratio is focused on debt vs profitability and is a measure of the companies’ ability to pay interest on outstanding debt. The ratio represents how many times the company can pay its obligations from the earnings the company has generated. The higher the interest coverage ratio, the lower the risk is that the company will not be able to pay interest.

Why are tech stocks being hit harder?

Generally, when interest rates are low, future profits are valued more highly. Conversely, when rates rise, promises of future profits become less valuable. This dynamic between interest rates and future profits weighs most heavily on new and growing companies where most profits are still years away, most emblematically in the technology sector.

The process of determining the fair value of a stock is called valuation. The most common valuation method is the discounted cash flow model (DCF). The main idea behind a DCF model is relatively simple: a stock's worth is equal to the present value of all its estimated future cash flows.

Let’s do a quick example to show how changing interest rates affects the future value of a company’s profits.

With an interest rate of 2%, a company forecast to make $1,000 in 10 years has a present value of $980.39. When the interest rate is at 8%, the same company in 10 years’ time only has a present value of $925.93.

The relationship between interest rates and company valuation weighs heavier on the technology sector. Some companies in the sector are making a loss to chase growth for future profits. As such, they are more heavily impacted in their valuation as their cash flows don’t exist until further in the time horizon.

Others had massive valuations placed on them during the pandemic as investors hunted for companies that would best weather the storm. These expectations are now coming off as investors price in slowing economic growth and rising interest rates.

“Growth and many technology stocks have been hit especially hard because of the long duration of their earnings,” explains Morningstar’s Dave Sekera.

“A significant part of the value of technology stocks is their future earnings profile, and as investors lower their growth expectations and/or discount those future earnings at a higher rate, the present value for these stocks falls further and faster than the broader market. In addition, market sentiment has turned negative on growth stocks, especially after Netflix (NFLX) fell off a cliff, dropping over 20% in one day following its earnings release.”

The dynamic between rates and valuation has been observed over the past year in the technology sector with the NASDAQ-100 Technology Sector Index falling 21% since January. The relationship can also be observed in Australia and has cost some market darlings. Block, REA Group and Xero are all down 35%, 37% and 41% respectively over this year.

A slowing economy and consumer confidence

As central bankers increase interest rates to curb inflation, they also induce a behavioural shift in consumer sentiment to reduce their spending. This is an issue for companies that are reliant on low-interest rates, strong economic growth and high consumer confidence.

For example, when unemployment and interest rates are low, consumers are optimistic about the future and spend more of their hard-earned money on goods and services they desire like dining out or a new TV. However, as rates rise and the cost-of-living increases, consumers become pessimistic and cautious about the future. Their focus has shifted from buying a new iPhone to managing their mortgage. They are more likely to continue to wear the shoes they already own rather than fork out an extra $200 for the newest kicks. This poses a threat for companies that fall in the “consumer discretionary” sector and cater to consumer wants as opposed to needs.

Let’s apply this concept to the current economic environment with rising interest rates.
This year Temple and Webster shares have fallen 58% whilst Coles shares have increased 5%. Overall, the consumer discretionary sector is down 13% over the last three months while the consumer staples sector is up 10%.

A reduction in consumer confidence can also lead to goods substitution. This means choosing a cheaper alternative when companies produce goods or services that differ slightly but serve similar purposes. The preference for a cheaper option may reduce the profit margins of companies in a competitive market. For example, if consumers switch from Netflix to Amazon Prime, the profits of Netflix will suffer.

Its not all bad news

Interest rates rising may harm certain sectors of the market, but this isn’t true for all sectors. In fact, there are some sectors that benefit from higher interest rates such as financials. As rates rise, the wider bank margins become.

Banks are successfully able to pass on cash rate rises to borrowers by increasing the rate of interest on loans while being able to fund themselves at a cheaper rate as savers rush to deposit their savings.

This can be observed earlier this month after the RBA raised the cash rate for the first time in over 10 years.

Australia’s big four banks wasted no time matching the Reserve Bank’s cash, each hiking their variable home loan rates.

Growth YTD | ASX Sectors

Source: Morningstar

Not only do certain sectors benefit from higher interest rates but different asset classes also benefit.

Using the banking example above, all of Australia’s big four banks also increased their savings rate. This incentivises investors to increase their cash holdings as they receive higher returns.

Moreover, bonds and interest rates have an inverse relationship. When interest rates rise, the price of bonds falls making the asset look more attractive to investors.