Let’s Stop and Zoom Out A Bit – Back to Basics 101

Keeping things simple, higher interest rates mean higher costs for ANYONE borrowing money. Driven by pure logic, that HAS to be bad for equity, right? In this article, we will put equity in the current market perspective.

After over a decade of rock bottom interest rates in most of the developed countries – rates are rising. Last week all eyes were watching closely what the Fed, the central bank of the USA, will do. We saw Fed hike its benchmark interest rate by 75bps (0.75 percentage points), which is the largest amount since 1994. Rates hikes are referred to as central banks policy rates (federal funds rate in the US, controlled by FED or deposit facilities rate from ECB). This is the rate at which banks lend money to one another.  What does that mean? When this referent rate hikes (like what we have at the moment!), it pushes all other interest rates in the economy (like mortgage rates, and bonds yields..). A higher interest rate simply means higher costs for ANYONE that borrow money (banks, consumers, companies..).

Federal funds effective rate & ECB’s deposit facilities

As can be seen from the graph above, we have had more than a whole decade of low interest rates. Both Fed and ECB kept rates their reference rates at historically low rates. But a fundamental shift starts to happen. As said above, last week Fed raised their reference rate – the federal funds rate. The key thing to point out here is, that the rate hike was higher than expected. Numerous expectations were put at 50bps or 0.50 percentage points. Also, according to the target range of individual members’ expectations, Fed’s benchmark rate is further expected to reach 3.4% as Fed vows to raise rates steadily over the next year.

But why now? What is different?

This is pretty easy to conclude – inflation. Inflation makes a completely different environment. We’ve had the longest-lasting bull run up to date, but inflation started to boil as a result of inflationary pressures and long-lasting easing monetary policy as money lifted the value of asets. Inflation is the „enemy“ that should be fought under every cost – even a recession. The primary goal of most central banks is this exactly – to keep inflation low and steady. This is an answer to why we expect further contractionary monetary policy and the continuation of rising reference rates. Because inflation happened and it just has to be controlled, simple as that.

What does all this imply?

In the world of fixed income (primary bonds) – there is a clear negative relation. As interest rates rise, bond prices fall. This simply happens as the return on those bonds becomes less attractive, due to higher current interest rates – and to compensate, the price of the bonds will have to decrease to have a higher implied yield.

What about equity?

How is equity’s value derived – what’s the first domino? Of course, sales. Now, in the rising rates environment, what can we expect sales-wise? Consumers will definitely see their budgets shrink. Car loans or mortgage payments will increase. Further borrowing via bank loans will also be more expensive and so, we can justify the expected demand for most products to decrease. In other words – lower sales are to be expected. Companies could, consequently, report lower margin and their profits reduced.

Let’s get into the stocks in a bit more detail.  This will be of high importance for each investor to know the classification of the company he invests in and believes in. As every investor probably knows, the most general stock division is on „growth“ and „value“ companies.

„Value“ stocks tend to perform better during the rising interest rate times, as they mostly sell price inelastic products – something consumers will buy regardless if, for example, their income falls. A good example of this would be a food company, like Podravka. People will buy Podravka’s products anyhow. What about the other side of the coin? So-called „growth“ companies. Those companies should experience harder hits by money being more expensive. Tech companies are a good example. They should be more affected as growth companies derive their value from future expected growth in cash flows, which in times of higher rates, carry more intrinsic risk within them.

Valuation-related reasons for lower valuations

There is also a pure mathematically-derived reason why companies become less attractive during said times. Stocks are often valued on the return they offer, compared to other opportunities in the market, like of course, bonds. Considering the risk/reward, higher-income yields could decrease stock prices via lower demand for stocks, as bonds could offer comparable yields with a much lower risk.

Also, the reason why growth companies should expect a higher downturn lies within the valuation assumptions that the equity market lies onto. Growth companies derive more of their value from expected future cash flows, in relative terms, compared to value companies. This said those expected cash flows will now be discounted by higher interest rates to come up to their present value of them. This effect should decrease the valuation of growth companies more noticeably.  But nonetheless, the whole equity should feel a lower valuation as reference rates increase.

As a cherry on top – we might see the self-fulfilling prophecy. Black-on-white, the USA might end up in a recession. To enter a recession, the USA needs to report two consecutive YoY quarter decreases. Last quarter decrease was already reported. If the following quarter also falls on a YoY basis, there will be an official recession – and the data comes out soon. Then, potentially this self-fulfilling prophecy might occur, as each headline will read „We are in a recession“. Not much of a sentiment boost, right? But nonetheless, we should not rush ahead of anything.

Domagoj Grčević
Category : Blog

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