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Interest rates as a monetary tool
The Central Bank of a country (RBI, in our case) has the responsibility to control the supply of money in the economy to keep a check on the inflation, sustain economic growth and achieve other economic objectives. Reserve Bank of India uses various monetary tools to achieve these objectives. Interest rates are one of the very prominent monetary tools used by RBI. We have looked at monetary policy in some detail in an earlier Jargon Buster article (Click Here). An increase in the interest rate will lead the bank rate or discount rate to go up. Bank rate is the rate at which RBI lends to the commercial banks. Commercial banks decide their own lending rates based on this discount rate. As a result, liquidity is usually affected as lending capacity of banks decrease with increase in interest rates and supply of money in the economy is reduced.
Lets look at how and why interest rates critically influence stock prices, from three perspectives :
- Liquidity perspective
- Valuation perspective
- Earnings perspective
Liquidity perspective
Usually, when RBI increases interest rates it very often also sucks out excess liquidity in the system in a bid to cool inflation. This can be done by reducing the amount available with banks to lend and also by making lending for speculative purposes including real estate and stock markets more costly for banks by increasing their provisioning norms.
An increase in the interest rate consequently lowers the liquidity in an economy as obtaining funds becomes costlier. In other words, individuals and corporates have to pay more for borrowing the funds. For individuals, this tightening liquidity leaves them with lesser disposable income and consequently leads them to lower their consumption of goods. Lower consumption hits the revenues of the businesses. Also, higher cost of borrowing leads the businesses to lower their investment and postpone their expansion plans. Lesser investment translates into lesser growth of the company and hence the stock prices of these businesses may fall down.
Another effect of lesser liquidity owing to high interest rates is the diminution in speculation activities. This takes a hit on the volumes traded in the secondary equity markets and a bearish sentiment settles in. A high selling pressure results in lowering of the stock prices. We are all too familiar with the term "liquidity driven rally" in our markets. Take out the liquidity by making it expensive to borrow and speculate - and you have a sure fire negative impact on stock prices. The sharp rallies we have seen in several asset classes including global equities, commodities and precious metals since 2009 are largely attributable to excess cheap liquidity that US, European and now the Japanese central banks flooded into world markets to re-inflate asset prices. If you are borrowing at 1 and 2% interest, you are willing to take on more risk and buy more risk assets. If the borrowing cost is say 10%, you will think twice about borrowing more money to speculate. Chances are that you will also unwind some of the speculative positions you have built up to pay back the loans as your confidence of making a profit of more than 10% is obviously less than the confidence of making a profit higher than say 2%.
A tight liquidity in an economy not only affects the secondary markets but also the primary capital markets as well. Corporates usually postpone their plans of raising equity when the supply of money in an economy is less.
The above relationships can be summarized as: High interest rates affect the lending capacity of the banks which sucks up the supply of money in the economy. This usually lowers the liquidity. Lower liquidity leads to lower speculation, lower consumption and lower investment. Consequently, stock prices come down.
Valuation Perspective
A relatively direct effect of change in interest rates is on the valuation of the business and the stock prices. Valuation of businesses is usually undertaken by methods such as discounted cash flows method. We have discussed DCF in some detail in an earlier Jargon Buster article (Click Here). The future cash flows are arrived at and they are discounted using an appropriate discount rate which is basically the required rate of return. Required rate of return is the return expected by the investors as a compensation for the equity risk. Higher the interest rates, higher will be the required rate of return as the investors require a premium over and above the risk free rates to compensate for the additional risk associated with investing in equity. This implies that a higher discount rate will affect the valuation of a business negatively as their discounted cash flows will reduce in value. Lesser valuation will lead to knockdown of stock prices.
Also, valuations of equity prices take a direct strike with an increase in the required rate of return. With methods like dividend forecast approach where expected dividends are discounted using the required rate of return, the fair theoretical price of equity will come down on account of a higher discount rate.
With an increase in the required rate of return, not only the existing business valuations are lowered, capital expenditure decisions are also affected. Methods of project appraisal like Net Present value, internal rate of return, discounted payback period all involve discounting of cash flows with the discount rate. Therefore, ability of a business to undertake investment based on these methods is also affected. We have already discussed the affect of lower investment on the equity prices.
Earnings perspective
Increase in interest rates increases the debt burden on businesses if they service interest using floating interest rates which is usually the case. An increase in the debt burden affects the net income of a business. As profit comes down, earnings per share also falls. A lower EPS will affect the value of a stock negatively.
For instance, Company A has net earnings of 1,00,00,000 and has 10,00,000 shares outstanding. Earnings per share works out to be 10. Now let's assume that the stock price is currently 100, therefore P/E multiple turns out to be (100/10) i.e. 10. Now if the net earnings drop to 90,00,000 on account of increased debt burden, EPS reduces to 9. With a P/E multiple of 10X, the stock value decreases to (10*9) i.e. INR 90.
A natural consequence of this is the higher P/E i.e. Price to earnings ratio. A high P/E ratio on account of lesser earnings will lead to a decline in the stock price as the stock will fail to attract investors.
A lower profit on the income statement of a firm will lower its ability to declare higher dividends. Lower dividends again translate into lower stock valuation as methods like dividend forecast approach, earnings price ratio approach discount the expected dividends to arrive at a fair value of equity.
In conclusion....
Interest rates are merely one of the numerous factors that affect the stock prices. Prices of stock result due to interweaving effect of many factors. After pondering over the relationship between interest rates and stock prices, we see that increasing interest rates are accompanied with lowering of stock value. Conversely, a low interest rate environment is usually good for stock markets - as a lot of cheap money is available for genuine commercial uses as well as for speculative excesses. It is usually very difficult to sustain a bull market in a high interest rate, high inflation economic situation. Bull markets are known to do well in the initial phases of a rate hike cycle - when the cost of borrowing does not become prohibitively expensive. But, as the rate hike cycle gains momentum and the "pain threshold" for producers, consumers and speculators is reached at various levels of interest rates, it does become increasingly challenging to sustain a bull market.
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