Interest Rates and Stocks: comparing numerators and denominators

For the past couple of years, we have been highlighting to our clients the fact that the market value of their bond portfolios will drop when rates rise. This is especially true of long-bonds.

However, we haven’t often explictly discussed the impact this can have on stocks. All else being equal, rising interest rates exert downward pressure on stock prices. There are four reasons for this:

Institutional investors and analysts use interest rates to value stocks by discounting future earnings or dividends. As rates rise, the present value of a future dollar drops, depressing valuation multiples.

In standard financial analysis, a stock is modeled as a very long bond (a perpetual) with uncertain interest payments (dividends or earnings). If we do this, the dividends are estimated as an annual or quarterly stream, and this is discounted back to today using the appropriate discount rate. As you can imagine, when the discount rate rises, this raises the denominator of the fraction and the current value of a fixed dividend stream falls.

Borrowing costs for companies rise, which means more revenue is diverted to satisfy financing requirements.

Any firm with variable rate debt or a need to roll over debt will encounter a higher cost of funding, and if all else stays the same, these higher payments eat into income available to shareholders. In the dividend discount model we described above, this reduces the value of the numerators, which of course leads to a fall in the current value of the dividend stream.

Higher rates also result in lower economic activity as  households and businesses find a larger percentage of their wallet share going to fund interest payments.

Businesses evaluating future projects use higher rates to review their attractiveness; marginal projects or investments are shelved since they are no longer profitable, reducing earnings growth.

At the same time, rising interest rates change the calculus for future projects and investment. A company building a new factory or launching a new product will analyse the future earnings and weigh them against current costs. Projects that look good when borrowing costs or rates are at 4%, may not be economically feasible at 6%.  Apart from financials, real-estate is the sector most sensitive to rates, but so is any heavy industry with significant capital costs.

Rising rates make bonds more a more attractive investment alternative for investors.

This is perhaps the simplest and most under-appreciated reason that higher interest rates lead to lower stock prices. As investors evaluate various investments, rising rates make bonds appear more attractive.

The counter-argument to these is that rising rates in our modern central bank led monetary regime imply broad confidence in the economy. We accept that this is broadly true, but will leave it till a later date to review the historical record.