Courtney C. Lipsey It would have taken living on an island on a deserted continent for 18 months not to know that interest rates are on the rise. After the pandemic, central banks are trying to get rates back to normal. Normalizing rates does not come without a cost, as those who purchased homes two or even three years ago know.
Higher interest rates also have an impact on investors. This week, I’d like to explore four ways that today’s high-interest rates impact your share portfolio.
Higher interest rates will have the greatest impact on your portfolio through increased borrowing costs. Both businesses and individuals are forced to spend more cash on debt servicing due to higher interest rates. The money that companies and individuals must pay as interest can no longer be used for hiring additional staff, investing in new machinery, office space ma, marketing campaigns, or any other growth initiatives. Individually, as more money is spent on mortgage payments, there’s less available for cafes, restaurants, and clothes. Higher interest rates will slow down economic activity for both individuals and businesses. It’s not unreasonable to expect that most companies listed on stock markets will face difficulties in increasing their profits when the economy is slow. Profits could decline in some cases, and in extreme situations, profits may disappear entirely.
A higher interest rate will then reduce the profits that your businesses generate. Due to lower profits, companies must pay out lower dividends to their investors. As investors adjust to this expectation, they will be willing to pay less for each share.
This is the basic logic. However, it is important to note that this is an extremely broad brush. Higher interest rates do not affect all companies listed on the stock exchange. Higher interest rates are usually beneficial to the banking sector. The banks make money by the difference between what they charge depositors and the interest rate they lend out. It is called their interest margin. Their margin is usually compressed when interest rates are low. As rates rise, they are able to increase their margins, increasing interest rates for loans while dragging their feet in raising rates for depositors. Higher rates are beneficial to the financial sector, especially the banks. This is true until higher rates cause a severe recession.
It is especially significant when it comes to the Australian share market, where our ten biggest companies account for almost half of the total market value. Five of the ten biggest companies are banks. This may explain why the Australian stock market has been more resilient than that of the US.
The banks are not the only ones to benefit or at least be less negatively impacted by rising interest rates. Stocks of consumer staples tend to do well when interest rates are rising. We are talking here about stocks such as Woolworths and Coles. The people are still buying groceries. Recent profit upgrades by the two supermarket chains indicate that consumers may be forgoing take-out and restaurant meals in favor of affordable luxury items like upmarket cheddars.
Higher interest rates generally hurt the share market, but some pockets are not affected.
Higher interest rates reduce the appeal of borrowing to invest for investors. It is not unusual to borrow money to invest in real estate. Borrowing money to invest in stocks isn’t as simple, but it still happens quite often. This is especially true for high-income earners who want to increase their wealth. Borrowing and investing in stocks was easy when the cost of borrowing was only two or three percent. In Australia, at least, dividends were usually enough to cover interest expenses, plus franking credit and the expectation of capital growth over time. With the recent rapid increase in interest rates, this becomes more difficult. In the past 30 years, Australian shares have averaged a return of just under 10% per annum. We can’t predict the future, but this gives us some reference. Interest rates above 8% don’t provide much room for the future to change. The share market is depressed, so some investors may be willing to accept higher interest rates today because they are buying at a low price. They also believe that rates will stabilize and possibly even fall in the future. It was much easier to justify the transaction when interest rates were around 2% or even 3%. Even if market prices had been inflated, it still made sense.
Thirdly, higher interest rates can affect your portfolio in a way that is common to professional investors. This involves a valuation method. The Discounted cash flow model is what it’s called. Analysts estimate future profits or dividends of the business and apply what is known as a “discount rate.” Still, it is actually an interest rate that determines the amount to be paid today for these future cash flows. I found an excellent illustration by Morningstar. If the 2% interest rate is applicable, you would have to pay up to $980 to buy the cash flow. If interest rates were at 8% instead, then you would only have to pay $925 today for the same cash flow.
Professional investors use this method to calculate the fair price of shares. As you can see from this example, higher interest rates reduce the estimate of fair value.
The impact of this is felt most strongly by companies that are growing rapidly, where the cash flow may be low now, but profits are expected to increase dramatically in the future. This is especially true for tech companies. The NASDAQ has a bias towards high-growth tech businesses, and this is why it has fallen more than the broader US and local markets.
Higher interest rates provide more options for investors. Back in the early 2000s, when I was working with clients, it wasn’t easy to convince them to invest a large portion of their wealth in what is typically called defensive assets. Bonds, term deposits, high-interest saving accounts. These investments were not worth it because the returns were so low. It was better to buy low-risk Australian shares and collect the dividend. In a world of low-interest rates, investors were able to invest their savings in the stock market.
The tide is changing as rates increase. For some clients, term deposit rates above 4% mean we are removing them from the stock market and returning to their preferred defensive investments. Even bonds that have suffered a terrible 18 months now appear to be reasonably priced. This is a good alternative for investors who are looking for greater stability.
The price of shares is a function of both supply and demand. When you buy a share, someone must be selling. Prices go up when there are more buyers and sellers. The opposite is also true. Share markets attracted investors’ savings during the low-interest rate period and pandemic. Now that we are on the other end of this journey, investors have reverted to lower-risk investments, which has created an environment where prices tend to fall.
Here are my four tips on how higher interest rates can impact your portfolio.
- Increased borrowing costs have a negative impact on economic activity. For most businesses, this results in a decline in profits.
- Higher borrowing costs reduce the appeal of leveraged investments for growth investors, thus reducing the number of buyers on the market.
- Discounted cash flow models, a method commonly used by professional investors, can be used to determine the impact of higher interest rates on share prices.
- Investors have more options to consider than ever before, thanks to today’s high-interest rates.
