The effect of rising interest rate

Karl O.Strøm
04/07/2022 | 6 min read

Most of the world's stock markets have suffered a significant blow this year and are in what is known as a "bear market"

Why is the interest rate so important for the stock market?

Most of the world's stock markets have suffered a significant blow this year and are in what is known as a "bear market". The term itself has no clear definition. Some use a fall of at least 20% from the top of the broad market indices as a limit, but this has mostly emerged as a way of classifying historical price falls. I would rather describe bear markets as follows:

  • Bear markets are prolonged periods of persistently sour market conditions, which visually can be seen as a series of lower peaks and lower lows in prices.

Given this description, one can actually ask oneself whether the sharp fall in the stock market as a result of Covid in 2020 was a bear market or just a correction. The fall was deep, but it quickly came up again and formed a single V-shaped bottom. The current situation is different, and interest rates are an important part of the blame. Let's take a look at why this particular single factor is so important.

Here we must consider some basic financial theory regarding the valuation of shares. Important points are these:

  • The value of a business is equal to the present value of the future cash flows it is assumed to generate (plus any sales value of the assets). In other words: What can you expect to get back in relation to what you pay.
  • Future cash flows are measured as earnings per share (EPS)
  • Calculating how EPS is assumed to develop is the job of the company analysts in brokerage houses.
  • Calculating the present value of future EPS means that an adjustment is made to the value for amounts going forward in time. A krone this year is worth more than one until next year, which in turn is worth more than one in 3 years.
  • Simply explained, it can be said that this is a reverse interest calculation. If you put money in the bank, the amount will increase with the interest rate and grow over time. In a present value calculation, EPS will in the long run be less valuable than profits close in time.
  • What counteracts this effect is that companies usually strive for their earnings to increase over time. In other words, they have goals for EPS growth.

From this one can draw at least two logical conclusions:

  1. The higher the expected future growth in earnings per share (EPS), the more the share is worth today.
  2. The higher the interest rate, the less future EPS will be worth today.

This is hardly dramatic new information for most people who trade individual shares. How great the effect can be in the situation we are in now may come as a surprise. It is easy to think that a little up on the interest rate is not so careful, and that we will only return to where we were a few years ago. Yes, that's right. But in the meantime, interest rates have been extremely low. Therefore, a normalization has a significant effect on the valuation of the shares. Let's do an example:

Imagine that a share has an EPS of 10. This is paid in full in dividends, and it is expected that the company will be able to grow this by 4% each year into eternity. What is this stock worth? We do not know yet. If you add a "return requirement" in the form of an interest rate, you will be able to illustrate the value through the relatively simple financial formula called "Gordon Growth Formula". First, however, we must know that the required rate of return in the formula consists of the combination of risk-free interest rate and a general risk supplement. Risk-free interest rates are e.g. the interest rate on bank deposits or government bonds. The risk premium for equities has historically averaged approx. 4%. If the risk-free interest rate is 1%, the interest rate used in the formula will thus be 1 + 4 = 5%.

In a low-interest world with a 1% government interest rate, an EPS that grows 4% annually into eternity will be highly valued. The share in the example will be priced at (10 / (0.05 - 0.04)) = 1000. In relation to this year's earnings of 10, this is a price / earnings (P / E) of 100. This is high, but in recent years behind us, many stocks have been priced much higher than this.

Let's say that there will be an increase in interest rates. The central bank raises the interest rate from 1 to 2%. Given the same calculation, this will give a share price of 500. In other words, a doubling of the risk-free interest rate will halve the share value in this simple formula. This is effect 1.

Let us say that the rise in interest rates also leads to slightly worse times in business, partly as a result of higher interest costs on debt. The company is therefore unable to grow its EPS by 4% annually, but only by 2%. If this is included in the formula, the share is worth 250. In other words, halving the growth in this example will also lead to a halving of the share price. This is effect 2. As earnings this year are the same, these two effects have now led to P / E being reduced from the sky-high 100 to the sober 25. Still a high number, but undoubtedly much lower than it was.

Description: This is an illustration of the Gordon Growth Formula. Column 1 is the starting point, column 2 is with a doubling of the risk free rate, and Column 3 is with doubling of risk free rate, and halving of EPS growth rate.

Relevance to the current situation

The example is simple, but it is easy to see its relevance in the current situation. Decades of downturn in interest rates brought us to a level that was very low. This in turn led to a rush for returns into equities and concepts such as TINA - There Is No Alternative (to equities). Now interest rates have risen. At the time of writing, one can buy 10-year government bonds in the US to get 3.17% interest over the next 10 years. For investors such as pension funds and the like, this is enough for them to meet their obligations. TINA is history and safe bonds are again an option for many who have been stock buyers in recent years. This means a lot.

The flow of capital into shares, and an artificially low required return (interest rate) thus led to high prices. It is in fact the direct mirror image of a low yield requirement. Given equal future earnings in a company, you will get a lower return the higher the price you pay for this income stream. It's pure math. We are now in a phase where interest rates and thus yield requirements are rising. As we can see from the examples, this in itself is enough to send share prices down significantly.

Then comes the second round of effects. As shown in the example, higher interest rates can also result in higher costs for companies, which in turn leads to lower growth in future revenues. This in turn results in lower share prices. There is a lot of talk about this in the market now. Analysts' estimates for earnings growth are high, especially in a situation where many companies have record margins. That these can be assumed to have to be downgraded will not be surprising. We have not shown this in the calculation example above, but if the profit per share (and thus the starting point for further future growth) falls by 20%, then the share price also falls correspondingly.

And thus we have a simple theoretical backdrop in place for the current situation in the market.

  • Do you believe in rapidly falling interest rates and a new increase in stimulus from central banks, or has the tightening just begun? What do the central banks say?
  • Should the growth in the companies' earnings be unaffected by higher interest rates and the other increases in costs? Or will this translate into lower earnings growth?
  • Are companies' profit margins expected to continue to rise from already record levels, or can they be expected to fall towards historically normal levels?

The explanation for the market turmoil of recent months can be found in these questions, and so can eventually the end of it. It is rarely the case in the financial market that there is only one factor to take into account. Everything is connected to everything. But the interest rate affects both the return requirement for investors, the companies 'costs and the investors' alternative (risk-free) return. It is therefore very important. And now it's on its way up. This creates headwinds in the market after a very long period where this factor has generally given tailwinds.

Disclaimer: After many years in the brokerage business, I wrote the book "Paleo Trading: How to trade like a Hunter-Gatherer" in 2021 and launched a hedge fund that trades on the same principles. Vontobel asked if I would write any posts for their blog, similar to what traders and managers do in other countries. I want to emphasize that none of what I write on this blog is to be considered as personal advice or concrete encouragement to take positions. Everyone must be responsible for their own decisions and familiarize themselves well with the products they use.


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