Interest rates and stocks are two of the most influential forces in the financial world. But their relationship is anything but simple. At first glance, these concepts might seem unrelated: one governs the cost of borrowing, while the other represents ownership stakes in companies.
However, interest rates are like the invisible strings pulling the stock market’s levers. Whether a rate hike or a rate cut, understanding how these forces interact can be the difference between riding the wave of financial growth and being caught off guard by market volatility.
So, what are interest rates, how are they set, and how do they affect stocks?
What Are Interest Rates?
Appropriately called the cost of money, interest rates tell borrowers what the cost of borrowing is and savers what the rewards for saving are. UK savings and borrowing rates are set based on the Bank of England’s Bank Rate.
The Bank of England is the UK’s central bank, and its Monetary Policy Committee is responsible for setting the price of money in the UK economy.
Similarly, the Federal Reserve’s Federal Open Market Committee sets the FED Funds Rate in the US, and the European Central Bank’s Governing Council sets the Key Interest Rate* in the Eurozone. The Bank Rate, FED Funds Rate and Key Interest Rate all do the same thing – dictate the savings rates and costs of borrowing in their respective economies.
*Though it is referred to as one interest rate, the European Central Bank’s Key Interest Rate comprises three different rates:
- Main Refinancing Operations (MRO) Rate: the rate at which banks can borrow money from the central bank for one week.
- Marginal Lending Facility (MLF) Rate: the rate at which banks can borrow money from the central bank for one day.
- Deposit Facility Rate (DFR): the interest rate banks receive on their overnight deposits at the central bank.
When these central banks lower interest rates, borrowing becomes easy for businesses, encouraging them to invest and expand. This often translates to rising stock prices. But one man’s joy is another man’s grief. When interest rates are lowered, savers are worse off since the interest rate on their savings is reduced.
On the other hand, when interest rates are raised, borrowing becomes more expensive for companies (they face higher interest payments on debt), but savers are better off.
Interest Rates And The Stock Market
Interest rates and stocks have an inverse relationship – when interest rates rise, the stock market tends to fall. As Warren Buffett, one of the greatest investors of all time, once said,
“Interest rates are to asset prices, what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset values.”
Below are a few reasons that explain this inverse relationship.
Discount Rates
Discount rates are used in financial models to estimate a company’s intrinsic value and what price to pay for its shares.
The discount rate used in financial models is often the company’s weighted average cost of capital (WACC). This is the collective term for the company’s:
- Cost of borrowing – the interest rate on the company’s debts and other interest-bearing liabilities.
- Cost of equity – the shareholders’ minimum required return for investing in the company.
When interest rates rise, so does a company’s cost of capital – debt service becomes more expensive, and shareholders expect a higher return. When interest rates decline, so does the company’s cost of capital.
Since the discount rate is in the denominator of valuation formulas (like the discounted cash flow formula), a lower discount rate will give a higher estimate of intrinsic value – future cash flows are perceived to be more valuable to the investor. This, in turn, leads to higher company valuations and stock prices.
On the other hand, a higher discount rate will give a lower estimate of intrinsic value – future cash flows don’t appear as valuable to the investor. This leads to lower company valuations and stock prices.
Given the following information about Example Industries, let’s perform a simple valuation and see the impacts of different discount rates.
5 year estimated annual cash flows | £1,000 |
Weighted-average cost of capital (WACC) | 6% |
Total shares outstanding | 100 |
Discounted Cash Flow Formula:
Where:
- CF = Example Industries’ annual cash flows
- r = Example Industries’ discount rate (WACC)
Using the discounted cash flow formula, Example Industries is worth £4,212 based on its future cash flows. Dividing this by the company’s total shares outstanding gives an intrinsic value per share of £42.12.
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Future Cash Flows | £ 1,000 | £ 1,000 | £ 1,000 | £ 1,000 | £ 1,000 |
Discounted Cash Flows | £ 943 | £ 890 | £ 840 | £ 792 | £ 747 |
Present Value | £ 4,212 | ||||
Intrinsic Value Per Share | £ 42.12 |
Once investors realise what Example Industries is worth, they will buy shares and push the share price towards £42.12.
Lower interest rates mean lower discount rates. Lower discount rates make future cash flows more valuable in the present, and the more valuable cash flows are, the higher the company’s valuation.
Now let’s assume the company’s discount rate increases to 15%. At this new discount rate, Example Industries’ intrinsic value per share falls from £42.12 to £33.52.
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
Future Cash Flows | £ 1,000 | £ 1,000 | £ 1,000 | £ 1,000 | £ 1,000 |
Discounted Cash Flows | £ 870 | £ 756 | £ 658 | £ 572 | £ 497 |
Total Present Value | £ 3,352 | ||||
Intrinsic Value Per Share | £ 33.52 |
When shareholders realise the company is worth less than the £42.12 from earlier, they will sell to lock in their investment gains, and the stock price will fall towards £33.52.
Higher interest rates mean a higher discount rate. A higher discount rate makes future cash flows less valuable in the present, and less valuable future cash flows equal lower company valuations.
Attractiveness of Alternative Asset Classes
When interest rates are low, holding cash and investing in bonds produce meagre gains. Because of this, investors move along the risk curve in search of higher potential gains – mainly to the stock market (equity). They accept the higher risk of investing in equities for the higher potential returns.
This movement away from low-return assets to the stock market increases its value as buying action increases prices. Lower interest rates cause investors to move from low-risk, low-return investments to higher-risk, higher-return investments.
On the other hand, when interest rates rise – and fixed-income investments, like bonds, become more attractive – the risks of investing in the stock market are realised. The returns from equities may not justify the associated risk, and investors may forego these higher returns for guaranteed returns.
Investors then move back down the risk curve towards bonds and cash since higher interest rates mean higher coupon and savings rates. Moving away from the stock market causes downward pressure on stock prices, and the market eventually falls.
Impacts of Interest Rate Expectations
Interest rates and the stock market are so intricately linked that central banks don’t need to change interest rates for them to have an impact on the stock market.
If investors suspect an interest rate rise, they will try to adjust their portfolio towards investments that can withstand higher interest rates. Similarly, if interest rates are expected to fall, investors may become more growth-oriented and invest in companies that thrive in low-interest rate environments.
What Companies Are Most Affected When Interest Rates Rise?
Companies with high debt tend to be the most affected.
High interest rates make company debts more expensive to service (pay off), and higher finance costs reduce profitability. Similarly, the higher interest rates may force the company to deploy more cash towards debt repayments, impairing the company’s financial strength and commitment to shareholder rewards.
What Companies Are Least Affected When Interest Rates Rise?
Since rising interest rates increase a company’s borrowing costs, companies with little to no debt tend to be the least affected in high-interest-rate environments.
Low-debt companies have significantly lower interest expenses to deduct from profit than their high-debt counterparts. Since higher interest rates have a minimal effect on these companies’ financial performance, they can weather high-interest rate environments well.
Companies with no debt fare even better.
Summary
Interest rates are powerful forces in financial markets, influencing stock valuations, investor behaviour, and corporate performance. Set by central banks, these rates act as both a guide and a lever for economic activity, shaping the financial landscape in which companies, savers and investors operate.
The inverse relationship between interest rates and stocks stems from fundamental principles. Rising rates:
- Increase the discount rate used to value future cash flows, leading to lower company valuations
- Diminish the appeal of stocks compared to ‘safer’ investments like bonds
But, the impact of rising interest rates isn’t felt equally across the corporate landscape. High-debt companies often face increased borrowing costs, which can squeeze their profitability, whereas low-debt companies are better positioned to weather the storm.
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