The rise in interest rates is currently one of the hottest topics in investment discussions. After seven years of historically low interest rates in the United States, the Federal Reserve Bank increased the rate for the first time since December 2015. Now, it’s expected that the Fed will bump the rates at least one more time before the end of 2017. How will this affect equity prices? In general, interest rates don’t have a direct impact on equity prices like they have on fixed income instruments. When interest rates change (or are expected to change), there’s a simple mathematical relation between the rate and the price of a fixed income instrument. The influence on stocks is much more complex, as we will see below.
For equity instruments, it’s not the absolute level of interest rates in the market that matters. What’s more important is whether or not the cost of borrowing for the company exceeds business growth. Indeed, the company attracts more funding to finance capital projects, business expansion, and M&A activities. All these things serve a single purpose – to increase net income. So when the cost of credit is higher than the expected increase in the earnings it is funding, a company will borrow less. Consequently, revenue growth will slow down and, all other factors being equal, stock prices will decline.
This is the “supply side” view from the perspectives of company owners. But what about the “buy side” view held by stock investors? If interest rates increase as expected, it becomes more expensive for banks to borrow money from the Federal Reserve and, in response, they tend to increase the cost of their credit. In fact, many loans (with floating rates) adjust automatically in such a situation. It then becomes more costly for the customers to use loans, and they tend to repay them rather than save, consume, or invest. Lower rates of consumption will generally slow down the economy and may result in revenue decline. If everything else remains constant, this will again lead to a decrease in stock prices.
Of course, this is a very simplified and theoretic approach and we’ll show how it may be outweighed by other factors. First, for smaller companies, it’s common to have growth rates that greatly exceed the average economy growth rate. For instance, if a company is achieving double-digit bottom line growth, a change in interest rates by 0.25% doesn’t place a significant constraint on, it and the company will continue borrowing until the cost of new funding does not exceed the anticipated business growth.
Second, the stock market is very volatile. Increases and declines of 1% per day are not unusual. For this reason, the impact of rising interest rates is really not that significant. It should rather be viewed as an indicator of the overall state of the economy.
Finally, it is important to consider how theory corresponds to reality. At first glance, there is no connection at all. From December 2008 to December 2015, when the Fed Funds Rate was 0.00% to 0.25%, the S&P 500 index grew 2.6 times, and experienced several sharp declines, such as in June 2011. So when interest rates are low, a change in rates has no significant influence on stock prices.
In summary, we believe that the impact of an anticipated rise in interest rates on equity stock prices in the United States is minor. However, such a looming change could have a negative effect on stock prices and it should not be fully disregarded. Prior to assessing its influence, potential investors should take into account more important factors, such as a company’s business perspectives and its industry’s competitiveness. Insight into whether consumption is growing and the rate at which the business is expanding, among other factors, area much more reliable indicators of stock prices than a minor increase in interest rates. While an increase in rates may cause some capital movements in the favor of fixed income instruments, stocks still offer much more attractive returns – with an elevated level of risk, of course.