Over the last year, the US Federal Reserve (Fed) has embarked on a path of aggressive monetary tightening, raising the federal funds rate by more than five percentage points.
This rapid hiking cycle marked an end of a decade-plus long era of low interest rates and moderate inflation which benefitted risky assets.
With such a sharp reversal, interest rates took center stage and continue to dominate the financial markets narrative. After all, the interest rate is the price of credit and the discount rate on all future cash flows. As such, rising rates have a profound impact on equities and all other assets.
As Warren Buffett once quipped, “the value of every business, the value of a farm, the value of an apartment, the value of any economic asset is 100% sensitive to interest rates.”
So the the first obvious question to pose is:
Why are interest rates rising?
In simple terms, central banks raise interest rates to combat inflation.
The mechanism here is simple. Higher interest rates make borrowing money more expensive. When the cost of credit goes up, the money supply is reduced. And as liquidity tightens, companies and individuals spend less and the economy slows down. When growth declines, inflation falls.
Inflation has been rampant across most major economies, so the majority of central banks around the world had to raise rates during the past year to tamper price increases.
Currently, however, the global economy has reached an interesting juncture. Certain central banks continue to maintain their hawkish stance and keep hiking rates to bring stubborn inflation down to their targets.
However, there is also a growing list of central banks which opt to pause their tightening cycles. This dovish camp now spans Australia, Canada, India, Indonesia, Singapore and South Korea. Central banks in this cohort are concerned that overly rapid tightening can cause a severe contraction in gross domestic product and propel a deeper than expected slowdown in their respective economies.
With this current set-up, understanding the interplay between interest rates, growth and inflation is critical.
However, another important angle to understand is:
How do rising interest rates impact the stock market?
Rising rates affect equities in three primary ways.
First and foremost, higher debt costs squeeze corporate profits. "Firms with a lot of debt are impacted by potential higher interest expense," says Bruce Liegel, former fund manager at Millennium and author of Global Macro Playbook, a monthly research series. “Small cap companies also underperform large cap companies, as they are typically more vulnerable to higher borrowing costs.” Consequently, such falling corporate profits will drag on stock prices.
Moreover, rising rates dim the economic growth prospects and can impact future returns for companies.
Secondly, rising rates decrease the present value of any business.
As already outlined, interest rates are the discount rate on future cash flows. So, a higher discount rate lowers the present value of future earnings for stocks.
When this occurs, stock prices tend to face downward pressure. To quote the Oracle of Omaha again, “the most important item over time in valuation is obviously interest rates. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that's a huge gravitational pull on values”.
This mechanism became most pronounced in 2022. Prior to the Fed’s tightening, many tech companies which generated little or no earnings saw their price-to-earnings (P/E) multiples inflate, as investors focused on their future earnings potential. As rates rose sharply however, these stocks succumbed to a severe sell-off because investors were no longer willing to pay a lofty premium for potential future earnings which became discounted to the present with a higher rate and became less valuable.
The third reason why stocks can underperform during a rate rising environment pertains to other asset classes.
Higher interest rates make less risky assets such as cash and bonds more attractive. During such times, bonds, certificates of deposit and other vehicles pay attractive yields. This, in turn, means that the risk premium (or the excess return above the risk-free rate) also rises.
As Ben Bernanke rightly pointed out twenty years ago, higher real interest rates raise the required return on stocks and “reduce what investors are willing to pay for them.”
For these three reasons, interest rates have a profound impact on the stock market.
However, monetary tightening affects different types of companies in divergent ways, so the next important question to pose is:
How do rising interest rates impact different types of stocks?
The first category that is most affected by elevated rates includes growth stocks.
Growth typically encompasses disruptive companies in rapidly expanding industries which are fueled by technological innovation and are deemed to grow at an above-average rate relative to their industry or the broader market.
Early on, growth companies concentrate on increasing revenues, often at the cost of delaying profitability and maximizing profits at a later stage.
So, growth stocks depend on cash flows in the distant future that are heavily discounted. They are, therefore, much more sensitive to rising interest rates. Higher interest rates have a greater impact on their valuations than the companies whose value comes from near-term cash flows.
In addition, as these firms tend to be in the early stages of development, they typically rely on credit, so higher borrowing costs can impact their growth.
Finally, high interest rates also often entail a decline in economic growth which can have an effect on future returns for such companies.
In contrast, companies considered value stocks tend to have predictable business models that generate modest gains in revenue and earnings but are anchored by today’s cash flows and asset values. As a result, they typically experience lesser volatility.
Many value stocks also offer income, as they tend to pay out substantial amounts of cash as dividends to their shareholders. During turbulent times of rising rates, investors prefer to park their capital in such companies, as they believe that they will not decline sharply and will offer some income.
The third important group of stocks contains cyclical companies such restaurants, hotel chains or retail businesses that rely on discretionary spending and thrive during bouts of economic expansion when consumers part with their cash more easily. Naturally, when money supply gets reduced and nominal spending becomes subdued, these companies suffer.
Finally, during rising rate regimes, investors also tend to favor defensive stocks which cut across companies which tap into the types of spending that occur no matter what the economy does. Companies such as utilities or pharmaceuticals offer products that consumers simply cannot shed, even when the money is tight. They are, therefore, viewed as less sensitive to economic cycles.
Conclusion
In conclusion, rate hikes are a powerful tool central banks have at their disposal to fight inflation. Tightening cycles, however, tend to negatively affect the stock market, with growth and cyclical companies feeling most of the downward pressure.
Financial media dedicate a lot of time to the subject of interest rates. Certain investors who are more preoccupied with individual positions in their portfolios, often fret over the obsessive focus market participants place on central bank policies.
However, the importance of interest rates cannot be overemphasized. Even Warren Buffett, who is much more revered for his stock picking prowess than his macroeconomic analysis, admitted without hesitation that interest rates “power everything in the economic universe.”
Further readings on rising interest rates:
The End of Cheap Labor – the Demographic Dilemma
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.