You’d have to have been living on a deserted island for the last 18 months to not know that interest rates have been on the rise. Central banks around the world are endeavouring to return rates to normal levels, following sharp cuts through the pandemic. Normalising rates is not without pain however, as many who bought homes two or three years ago are very well aware right now.
But higher interest rates have impacts for investors too. So this week I wanted to dig into four ways in which today’s higher interest rates are impacting your share portfolio.
The most direct way that higher interest rates impact your share portfolio is the impact that they have on borrowing costs. Higher interest rates mean that both businesses and individuals must spend more of their available cash servicing debt. Cash that they now have to pay out as interest cannot be used to hire additional staff, invest in new machinery or office space, a new marketing campaign, or some other growth initiative. At the individual level, more money going out the door in mortgage repayments means less money available to spend on cafes, restaurants, clothes, and all the other discretionary things that make us happy. For both businesses and individuals then, higher interest rates slow economic activity. In an environment of slower economic activity, it’s reasonable to expect most companies listed on the stock market to face challenges in growing their profits. In some cases profits might decline and potentially in extreme cases profits might evaporate entirely.
Higher interest rates then impact your share portfolio by reducing the profits of the businesses that you own. As a consequence of lower profits, businesses must pay lower dividends out to their investors, and as investors adjust to the expectation of lower dividends, they are prepared to pay less per share to own that business.
This is the high level logic, but it must be recognised that this is a very broad brush. Not all businesses listed on the stock market are negatively impacted by higher interest rates. The banking sector for one is typically a beneficiary of higher interest rates. Banks make money through the difference between the rate that they pay depositor’s, and the rate that they then lend that money out at. This is known as their interest margin. When interest rates are very low their margin tends to get compressed. In reverse however as rates rise they tend to be able to expand their margin, raising interest rates on loans, whilst dragging their heels lifting rates available to depositors. The financial sector then, and particularly the banks, is a beneficiary of higher rates, at least up until the point where higher rates lead to a harsh recession.
This is particularly significant in the context of the Australian share market, with our ten largest companies comprising almost half the market value. Of those ten largest companies, five are banks. This is a partial explanation for why the Australian share market has proven more resilient than its US counterpart.
But the banks aren’t the only stocks to benefit, or at least not be harshly impacted by higher interest rates. Consumer staples stocks tend to fare well in a rising interest rate environment. Here we are talking about stocks like Coles and Woolworths. People are still going to buy groceries, and in fact recent profit upgrades from the two supermarket chains indicated that consumers were perhaps forgoing restaurant meals and takeaways, and spending a little more at the supermarkets on affordable luxury’s like upmarket cheeses.
Higher interest rates then are a negative for economic growth, which broadly hurts the share market, however there are pockets of the market which are immune.
The second way higher interest rates impact your share portfolio is that they reduce the attractiveness for investors to borrow to invest. Borrowing to invest in property is quite unremarkable and rarely given much thought. Borrowing to invest in shares is not as easy but it’s still reasonably common, especially for high income earners looking to accelerate their wealth creation. When the cost of money was two or three percent, borrowing and investing in shares was a pretty easy play. Looking at Australian shares at least, the dividends alone were typically enough to cover the interest expense, plus franking credits and the expectation that in time you will achieve some capital growth. But with the rapid rise in interest rates that we’ve seen, that gets tougher. Over the last 30 years Australian shares have on average returned a little under 10% per year. Clearly none of us know what the future will bring, but that gives us a bit of a reference point. Interest rates of 8% plus then, don’t leave a lot of room for things to unfold differently in the future. Now the trade-off here is that share market prices are depressed, so some geared investors might be prepared to endure today’s higher interest rates on the basis that they’re buying in at an attractive price, that interest rates will likely stabilise and potentially even go down in the future, and so with a 10 year type timeframe, the transaction makes sense. But without question it’s a lot easier for it to make sense when rates were at 2% or 3%, even allowing for the fact that perhaps market prices were a little inflated.
The third way higher interest rates affect your share portfolio concerns a valuation methodology commonly used in the professional investment space. It’s known as the Discounted Cash Flow Model. Analysts estimate the future profits of the business, or in some cases future dividends, and then apply what’s known as a discount rate, but effectively is an interest rate, to determine what the appropriate amount to pay today is for those future cashflows. I came across a great illustration done by Morningstar. If you were looking at an investment that would pay you $100 every year for the next 10 years, so therefore $1,000 in total over that period of time period, if the interest rate applicable was 2% then you should be prepared to spend up to $980 today to purchase that cash flow. But if interest rates are instead at 8%, then the discounted cash flow calculation tells you to pay no more than $925 for that same cash flow.
Professional investors use this methodology to determine a fair price to pay for shares. Higher interest rates, as you can see by this example, reduce the fair value estimate.
This impact is particularly harshly felt on strongly growing companies where cash flow might be minimal now, but the expectations are there profits are going to grow very strongly in the future. Tech type companies are a prime example of this, and that’s why you’ve tended to see the NASDAQ, with its bias towards high growth tech businesses, fall more so than the broader US market, and certainly more than our local market.
The fourth and final way that higher interest rates impact your share portfolio is that they provide investors with more alternatives. Working with clients a few years back, it was hard to make the case to have significant portions of wealth in low risk, what would typically be called defensive, type assets. Bonds, term deposits, high interest savings accounts. The returns were just so low that these investments didn’t make any sense. You were better off buying low risk Australian shares and simply collecting the dividend. So in a low interest rate world, the share market drew in some investors savings that would perhaps ordinarily not be in the market.
As rates rise, that tide is turning. Term deposit rates of 4% plus mean that for some of our clients, we’re backing out of share market investments and returning them to the defensive investments that are their preference. Even bonds, which have had an horrendous 18 months, now look to be quite reasonably priced, providing another alternative for those investors seeking greater stability.
Share prices are a function of supply and demand. Whenever you buy a share, someone else must be selling. When there are more buyers than sellers, prices go up, and of course the reverse also applies. During the extreme low interest rate period through the pandemic, share markets were like a magnet for investors savings. But now we’re on the other side of that journey, the magnetic pull has switched back to low risk investments for some investors, creating an environment of increased sellers, with its natural tendency to depress prices.
So there you have my four ways that higher interest rates impact your share portfolio.
- increased borrowing costs impact economic activity and for most businesses this is a negative, depressing profits.
- higher borrowing costs impact the attractiveness for growth investors to undertake leveraged investments, reducing one source of potential buyers in the market.
- higher interest rates impact share price valuations when using the discounted cash flow model methodology, an approach commonly used by professional investors.
- today’s higher interest rates provide investors with more viable alternatives to share market investments.