Recently, I wrote an article to caution the readers about the euphoria in the innovational technology stocks. In less than two weeks, many such stocks have crashed more than 20%, led by the stock market darlings such as Tesla, Square and Roku.
So what happened? You may not realize that the driver behind is the rising interest rate expectation. And you may wonder, “Isn’t the interest rate low now? How does interest rate affect stock prices? Will there be a broad market sell-off?” I will explain in this article.
The interest rate is often an overlooked factor for stock investors. Many mistakenly think that the interest rate is something that only bond investors or savers should worry about. You couldn’t be more wrong. The fact is, interest rate movement has a profound impact on stock prices too.
There is a reason why investment professionals are paying a great deal of attention to the central banks’ interest rate policies. When it comes to stock investing, you often hear people argue about a company’s earnings, future potential, etc. Well, these are important factors. But they have to work in a macro environment. It is like you can drive a Ferrari or a Porche, but in a traffic jam, everybody moves at the same speed. The interest rate is the traffic condition.
The interest rate affects all assets, from stocks to bonds, from real estate to commodities. In this article, I will focus on explaining how the interest rate affects stock prices. Like all my articles, it is for educational purposes and I will try to make it easy to understand by simplifying certain technical aspects.
The interest rate has been forgotten for far too long
When was the last time people talked about the interest rate as an investment return opportunity?
If you are in your 30s to 40s, you probably never cared about interest rate return because it has been too low since your adult life. If you are a pre-retiree or a retiree, you have probably been struggling with the low-interest environment because you had nowhere to put your savings to earn a decent return without taking excessive risks. That is why short term endowment plans have become very popular nowadays.
The situation that we are going through is caused by “Financial Repression”. This is when the central banks intentionally keep the interest rate low as a form of debt reduction for themselves.
The interest rate is the price of our time. When the interest rate is cut, our time is stolen. – Ivan Guan
The COVID-19 global pandemic has pushed financial repression to the extreme. The US 10 year Treasury yield dropped to 0.6% in March and this has stayed below 1% until December 2020. People are getting complacent, especially since the US promised a “lower for longer” interest rate environment.
But in the past few months, I have been telling my clients that this will not last. (Join my Telegram Channel for daily updates) I wrote this article in September last year. At the time, I pointed out a few things.
- Inflation will catch up due to the pandemic.
- Inflation will push up the interest rate.
- A higher interest rate will cause the collapse of certain stock prices.
Additional Reading: Average inflation targeting – how it kills your retirement plan.
Given today’s market environment, these predictions have come true. If you look at the chart below, the 10-year Fed yield has skyrocketed to 1.5% in just 2 months, a 50% jump!
Why should you care about the US interest rate?
The first question you may ask is why should you bother about the US interest rate. I have briefly touched on the technical details here. In a nutshell, Singapore does not have an overt interest rate policy, but instead manages the value of the SGD against a basket of currencies that belong to its major trading partners. That is why movement in the US interest rate will have a major impact on Singapore’s interest rate.
In fact, as a financial powerhouse, the US interest rate policy influences the rates of all major economies. If you recall, when the US went into unlimited “Quantitative Easing” in March last year, we could see all the central banks follow suit.
The interest rate is the anchor for all asset prices.
Here is where things are going to get a bit technical.
Imagine that today your fixed deposit account gives you 4% and you have an option to invest in a bond with a 3% coupon. Would you invest? You won’t.
Loosely speaking, we can think about the interest rate as a “risk-free” rate. It means you will get the promised return without worrying about the risks – it is guaranteed. A typical example is the CPF interest rate. In recent years, a lot of people have been topping up their CPF accounts. Essentially they are using cash to “invest” into a very long duration “CPF bond” with a “risk-free” return, even though the CPF interest rate is not explicitly guaranteed.
But what if the prevailing interest rate is higher than the CPF interest, will you still be interested in topping up? The US Treasury bond, which is touting as the world’s safest asset, has dropped 20% in the past 6 months. I wonder what will happen if the “CPF bond” is tradable.
But the interest rate doesn’t just affect the bond market, it affects stock prices as well.
So it is not surprising that if there is an opportunity to invest your CPF money in stocks, you will ask, “Can this stock give me a long term return that beats the CPF interest?”
In financial modelling, this is called the Capital Asset Pricing Model (CAPM). The formula for calculating the expected return of an asset given its risk is as follows:
This looks very complicated, it basically means
Expected Return = Risk Free Return + Risk Premium
How does this apply to your investment decision?
- If you want to invest, the investment return must be higher than if you were to put it in a risk-free instrument.
- The risk premium varies due to the nature of the investment and perceived return.
- If the risk-free rate increases, the expected return increases even if the level of the risk you take stays the same.
Because a government bond is often considered risk-free, government bond yields are the anchor for all asset prices. You use it to calculate the risk of all investments. That is why the movement of government bond yields will affect everything.
The interest rate impact varies in different stock sectors
However, the impact of an interest rate movement is not uniform because every stock is different.
2020 was the best year for technology stocks, but it was an exceptional year for non-profitable technology stocks. Skyrocketing is not enough to describe the price movement of the innovative technology sectors.
Have you wondered, why do people buy the stock of a company which doesn’t even make money? I will delve into this topic a little deeper to explain how Wall Street looks at asset prices.
That is where we need to talk about the Discounted Cash Flow (DCF) model. DCF is a valuation method used to estimate the value of an investment based on its expected “future” cash flows. The formula is as below.
Again, it looks complicated. But let me simplify it for you. DCF analysis is a financial analyst’s bible to figure out the value of a company based on projections of how much money it will generate in the future. It assumes that a stock price should reflect the “discounted” future cash flows.
If you notice, the keyword here is “discounted”. Discount Rate (r) is in the dominator, and its value is based on the Weighted Average Cost of Capital (WACC). You can understand WACC as shown below:
WACC = Cost of Equity Financing + Cost of Debt Financing
Ignore the technical aspects, what this means is as below:
- The company doesn’t have to make money today as long as people believe it can generate cash flow in the future.
- If people believe in higher growth in the company, they project a higher cash flow in the future, which leads to a higher stock price.
- The Cost of Equity is determined by the “Expected Return” which we talked about in the previous section. The lower the interest rate, the lower the expected return.
- The Cost of Debt is determined by the interest rate. The lower the interest rate, the lower the cost of borrowing.
- Therefore, a lower interest rate will have a combined effect of a lower discount rate r.
- Because the discount rate is the dominator of the formula, the lower the discount rate, the higher the valuation.
- Using secondary math, you can derive that a higher projected future cash flow and lower discount rate leads to exponentially higher stock prices.
Let’s draw some conclusions
If this still sounds confusing to you. Not to worry. Let me summarize for you.
First of all, you need to understand the stellar performances of many technology stocks were not just because of the wider adoption of their products and services, but more importantly, it was due to the valuation method used.
- Unlimited quantitative easing provided ample liquidity
- Low-interest rates lead to a rapidly declining discount rate.
A discount rate reduction has an “exponential” impact on stock prices due to the multiplier effect. But it works both ways. When the interest rate starts to rise, the downward pressures for such stocks are extremely high. As well, the stock market will start to “re-value” the stocks and downgrade the target prices.
That is why it is not hard to see that stocks in the tech sectors, such as Nasdaq 100 or Hang Seng Tech, have been sold off lately.
But this doesn’t necessarily mean a broad-based market decline. For example, Tesla, the market darling has fallen 25% since its high in February while JPMorgan, the shares people no longer talked about is moving in the opposite direction.
How should you invest now?
The rising interest rate is definitely affecting the stock markets but the impact varies for different stock sectors. Let me give you some examples.
- Technology shares: high growth companies will suffer the largest decline when interest rates rise. This not only applies to the IT sector, but to the biotech sectors as well. The more uncertain the future growth, the higher the fluctuation.
- Bank shares: high-interest rates means a higher profit margin which boosts the earnings. But it can also cause a markdown of their fixed-income assets in the accounting books. So you need to relook at the structure of the banks you invest with.
- REITs (Real Estate Investment Trusts): high-interest rates mean higher financial costs but it can also mean higher demand for this asset given its perceived inflation-hedging value. People may also shift back from growth to income when market speculation subsides.
- Commodity stocks: high-interest rates are always associated with a high expectation of inflation. The rise of commodity prices may boost the profit margin of the producers. It will be an interesting sector to watch.
A high-interest rate environment is not all bad for the stock market. In fact, research shows that the S&P 500 index has delivered good returns most of the time during a rising rate environment in the past.
And if we really zoom into this topic a bit more, it is the speed of increase that matters more than the rate itself. But I will leave it for another article (subscribe below for the email alert).
With the change of the market environment, you should re-look at your portfolio and see if there is a need to make adjustments.
I think the most important thing you should look at now is to invest in a company that is already making money, not some potential future growth. Because the higher the interest rate, the more projected growth will be “discounted”. Try to find companies that can benefit from a high-interest rate environment and not be a victim to it.
I hope this article can help you make sense of the recent market correction. If you like this article, subscribe below or join my Telegram Channel for frequent updates.