Daniel Reynolds: Why the stockmarket hates rising interest rates

OPINION:

There are many forces at play when investing in markets, but few have as much impact as interest rates.

We have seen interest rates fall to historically low levels, although some market commentators expect them to gradually rise over the medium term as the pandemic is brought under control and economic activity recovers.

Easy central bank monetary policy has underpinned a decade of exceptional equity market performance as investors have turned to riskier assets to generate acceptable returns.

This has colloquially been known as the TINA trade – There Is No Alternative (to equities).

Over the past 10 years, the US equity market has generated a 298 per cent total return while the NZ equity market has returned 267 per cent on the same basis.

In comparison, the prior 10-year period (2001-2011) saw the US equity market deliver a 31 per cent total return and the NZ equity market a 78 per cent return.

One of the key determinants of future equity market returns, and perhaps the most debated topic of today’s financial market, is the future direction of interest rates.

Those expecting higher interest rates often highlight growing fiscal support, rebounding GDP as the global economy emerges from Covid-19 restrictions, and emergent inflation they expect to persist.

Those in the “lower interest rates for longer” camp often highlight the potentially transitory nature of inflation and possibly unsustainable debt burden should interest rates shift higher.

Putting aside that debate for now, if interest rates do move higher there will be a meaningful impact on equity market returns.

Tighter monetary policy slows activity, debt servicing costs increase for heavily indebted companies – and if higher interest rates are in response to stronger inflation, business input costs will also typically rise.

These factors act to reduce company earnings and cash flow, in turn negatively impacting share price performance.

In isolation, higher interest rates also act to increase the cost of capital, which has a negative impact on company valuation.

However, financial markets are rarely so simple or predictable, and there are steps investors can take to maximise equity returns during a period of higher interest rates.

1. Earnings and cashflow are key drivers of share price performance, which fare best in a rising interest rate environment?

With rising interest rates, investors face opportunities and risks. Moderately rising interest rates need not be a strain on equity returns, especially when they are driven by expectations of higher economic activity.

Prior to the start, and during the initial stages, of an interest rate hiking cycle, economic growth is typically robust and inflationary pressures are starting to build.

Short-term interest rates, set by central banks, are typically rising slower than long-term rates set by market participants. During this steepening yield curve period, cyclical or “old-world” value stocks tend to outperform the broader market.

Cyclical stocks are those whose fortunes follow the economic cycle of expansion and contraction. Earnings and cashflow increase when the economy is doing well, but typically decline during challenging economic times.

Building materials, transport, energy and retail sector companies are examples.

As the economic cycle matures, inflation-targeting central banks typically respond with higher interest rates to contain price pressure.

Economic growth can slow around this time and cyclical companies may fall from favour. On the other hand, companies that have pricing power and hence some level of protection to rising input costs typically find favour.

Companies with inflation-linked revenues, such as listed property vehicles or infrastructure stocks, or those with revenue pricing power (including healthcare and some technology companies), typically maintain profit margins better than those operating in more competitive sectors.

Commodity-linked companies, like those in mining, can also benefit from rising commodity prices. Finally, many financial sector companies have positive earnings leverage to higher interest rates, such as banks or insurance companies.

2. End of an era for a rampaging technology sector?

While a company’s earnings prospects are a key driver of share price performance so is its cost of capital, which has a meaningful impact on equity valuation.

Higher interest rates are typically associated with a higher cost of capital. A company’s cost of capital is the rate at which future cashflows are discounted to value a company today, using the prevailing discounted cashflow valuation methodology.

Hence, higher interest rates typically lead to a higher cost of capital and a lower valuation.

The negative share price impact of a higher cost of capital can be most obvious in high growth companies, particularly as longer-term interest rates increase.

These companies are expected to generate increasingly larger cashflows into a long-dated future. Examples include the large or mega-cap technology companies. These drove US equity market returns more than any other sector over the past decade, during a period of easy monetary policy and low interest rates.

3. There Is An Alternative (to equities)

The low or negative real interest rates on offer from traditionally less risky investment options, such as term deposits, savings accounts, or government bonds have forced savers into riskier assets to generate an acceptable investment return. Lower quality credit and dividend-paying equities have been the chief beneficiaries of that rotation from lower to higher risk securities.

To the extent that interest rates rise faster than the rate of inflation, improved real interest rates on lower risk investments are likely to attract investor capital out of higher-risk equity markets.

In particular, those investors with a shorter-term investment horizon – retirees for example – may well prefer capital-preservation-plus-income over higher-risk capital growth investment options, such as shares.

The future path of interest rates is among the most debated and important topics in financial markets, as it impacts almost all asset prices, not least equities.

In broad terms, higher interest rates are negative for equity market returns, but rarely are financial markets so clear cut. Individual stock and sector returns in a rising interest rate environment will vary according to several related factors.

These include stage of the interest rate cycle, company-specific factors including indebtedness and revenue pricing power, and finally, a changing opportunity cost of capital.

– Daniel Reynolds is Managing Director, Institutional Equities.

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