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The threat of rising interest rates has been dominating financial headlines for months now. Surging inflation prints globally has prompted central banks, including the Reserve Bank of Australia, to consider tightening monetary policy and increase interest rates far sooner than expected.

In 2020, the RBA stated that they would not increase their targeted cash rate of 0.10% for at least three years. However, we are in the early months of 2022 and the market is projecting the RBA’s cash rate to rise to 1.20% by the end of 2022.

With all this financial rhetoric surrounding the imminent tightening on monetary levers, it is crucial for the broader population, not just finance professionals, to understand exactly how interest rate movements impact listed companies and their stock prices.

High Interest Rates = Reduced Stock Valuations

A company’s fundamental value represents the current value of all the future cash flows, that the company is predicted to produce. If you conclude all the annual cash flows a company is expected to produce in the future, discount them by an interest rate to account for the time value of money and add them up, you derive a company’s intrinsic value. If you divide this value by the amount of shares a company has issued, you get the intrinsic value per share and the price at which you should be aiming to buy a company’s shares at or around. Of course, key assumptions about a company’s future are made to be able to calculate a company’s intrinsic value, where these assumptions are inevitably not going to be exactly right. However, the derived target price serves as a rough indicator of value.

Interest rates can be compared to gravity when it comes to their impact on stock valuations. Higher interest rates increase the rate, at which future cash flows are discounted. Therefore, each dollar of future earnings is worth less today when interest rates are expected to be higher. This consequence is particularly true for ‘high-growth’ companies, as the bulk of their cash flows are typically expected to occur further out in the future compared to more stable companies. For example, cash-generative businesses such as Woolworths and Coles. When cash flows are further out in the future, the heavier the discount and thus the lower the present value of the cash flows.

Two examples of these high-growth companies are Xero and NextDC. These two companies are phenomenal businesses. However, they both invest heavily in future growth projects, thus foregoing current profitability for potentially greater future profitability. Therefore, the bulk of their profits are in the future, as opposed to a Wesfarmers or BHP.

The multiple at which investors are willing to pay for a company’s earnings also declines whenever inflation or interest rates rise. In every one of the seven phases of rising interest rates over the previous four decades, the US S&P500 12-month forward price-to-earnings ratio declined. This is partially due to the third reason listed below; as rates rise bonds become more attractive, thus the premium investors are willing to pay to own equities decreases. When price-earnings multiples are contracting, the only offset for share prices is rising earnings. To offset the multiple declines, the underlying company must grow profits.

High Interest Rates = Bonds Become More Attractive

Fixed income, or bonds, is the asset class that becomes the most attractive relative to equities when interest rates rise. This is because bond holders, given they hold the bond to maturity, receive the return of the interest rate on the bond when its issued, known as the coupon rate. In 2014, the Australian 10-year bond yield was a competitive 4.5%. During the depths of the Covid-19 pandemic of 2020, this yield fell as low as 0.68% and has now risen back to about 2%.

When bond yields are this low, investors typically allocate a larger portion of their portfolios to equities. Holding bonds throughout such an environment can lead to a two-pronged adverse result for investors: low returns through depressed coupon rates and capital losses if the bond is sold before maturity. In a low interest rate environment as we currently find ourselves, rates have nowhere to go but upwards. This puts bond holders in a tricky place where they will not only receive a lower yield relative to prospective higher yielding issues. But they will also endure a capital loss on their principal as investors sell old bonds to buy the new higher-yielding bonds, and in the process adjusting the yield on the bond to reflect current interest rates by pushing the price down. For example, let us say a bond issued at $100 yields 2% at issuance. If interest rates rise to 3%, the bond price will fall to approximately $67 to reflect the current yield of 3%, where the initial bond holder has lost 33% of their principal.

This is a long way of explaining that when interest rates rise, new bonds with higher yields become more attractive to investors. Especially institutional fund managers seeking a diversified portfolio for their clients. When bond yields are at historic lows as they have been, these fund managers have nowhere else to park investors’ capital other than equities. Particularly dividend yielding equities, as a means of achieving the yield component of their portfolios. Therefore, when interest rates rise, bonds become increasingly attractive to investors, and they sell out of equities to buy bonds.

High Interest Rates = Increased Future Debt Repayments

Companies with relatively high levels of debt are more exposed to higher interest rates than those with lower levels of gearing. This is particularly true if debt is continuously issued to maintain business operations and/or if the current debt on the balance sheet is not fixed and thus interest expenses move in tandem with interest rates. For these businesses, rising interest rates will have a direct impact on the income statement, reducing profits.

An example of a company with high debt levels is Transurban Group, an ASX-listed toll road provider. The company borrows vast amounts of capital to build and operate toll roads in Australia, the United States, and Canada. Transurban Group currently has $17.5bn worth of debt on its balance sheet, which represents 115% of its equity. This is compared to a capital light business such as the fund manager GQG Partners which holds no debt on its balance sheet. When interest rates are expected to rise, the market ‘prices in,’ or reduces its intrinsic value estimates, of the impacted the stock to reflect the future rising debt repayments even if most of the debt is fixed to a lower interest rate for the near-term. This is because the stock-market is forward looking by nature.

High Interest Rates = Can Cause Economic Growth to Contract

Pre-emptive tightening by central banks may well reduce economic activity before it has become sustained. Central bankers are caught in a tricky situation in this respect; potentially surging long-term inflation and restricting economic growth pre-emptively. This is particularly true given the current global economic landscape, which is masked by geopolitical tensions, a pandemic, supply chain issues, just to name a few.

The Australian Household debt-to-income ratio currently sits at 140%. That is, for every $1 a typical household earns, they owe $1.40. This means that a 1% rise in interest expense effectively equates to 1.4% of total income. Furthermore, fresh homeowners who recently bought their homes during peak house prices will likely be facing higher mortgage repayments because of higher interest rates. This could lead to an influx of homes being put up for sale as mortgage repayments become unaffordable, which pushes up supply, driving down the prices of all existing houses, causing more people to sell due to lack of equity, and so on. Simply put, the high levels of household debt make Australian families prone to rises in the cost of debt servicing if wages do not rise in tandem. The market takes these macroeconomic concerns into consideration when eyeing off imminent interest rate rises.

This is just one example of how interest rate rises could adversely impact the economy if central bankers get their timing wrong. There are a multitude of adverse impacts that excessive or poorly timed monetary tightening can have on an economy. Such as plummeting business investment, consumption collapsing and a lack of export competitiveness due to an appreciation of the currency. All of these reduce the level of an economy’s economic activity. Central banks around the world face hard challenge, and I do not envy them.

chart interest rates

Summing up

It is important to note that it is the trend in interest rate movements; which is frightening investors, not the absolute level of rates. To explain what I mean by this, let us say the RBA cash rates moves from 0.10% to 0.25%, the cash rates has increased by 150%, however the absolute level of rates remains at historic lows. Interest rates will remain at incredibly low levels, relative to historic levels, for at least the near-term.

Once bond rates stabilise, it is likely stock markets will cease dropping so quickly. Despite all the historical interest rate cycles, equities have continued to outperform every asset class, and they will continue to do so.

In conclusion, stay the course. Continue to view share price declines as an opportunity to load up on the most successful businesses at a discount. There are worst events than rising interest rates that have occurred throughout history and equity markets have nonetheless continued to soar over that time.

Written by Lachlan Hyde
Portfolio Implementation and Dealing
Oracle Investment Management

Luke Durbin

Get in touch with us today for complimentary consultation to discuss your financial position and we can provide you advice tailored to your unique situation.

Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.
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