Rising interest rates is a phrase that has seldom been relevant to Australian investors for the last ten years. But the Reserve Bank of Australia (RBA) is on a rate rise rampage to combat record-high inflation and decelerate the pace of economic growth, following in the footsteps of Central Banks around the world.
Far from abstruse economic policy, interest rates have an enormous impact on company earnings and equity markets, as everyone engaging in the US market has seen this year. In conjunction with rising rate expectations has come escalated volatility and negative returns as investors’ price in rate rises, reappraise growth expectations and refocus on the rudiments.
Changes in interest rates can affect companies and equity market performance. As interest rates increase, debt servicing costs rise and pinch profits. Valuations, particularly for growth sectors like technology, can be impaired by a jump in rates. Finally, higher rates repress inflation by slowing the economy, an essential derivation of profit for companies.
This article explains the impact of rising rates on equity markets and uncovers the sectors best positioned to prevail in the current market.
What are interest rates?
Most people define the interest rate as the amount banks charge borrowers on their loans. However, interest rates are much more extensive than the retail rates banks use.
Australia’s cash rate, set by the RBA on the Tuesday of every month, governs how banks collaborate their rates.
As the RBA defines it, the cash rate is the “rate charged on overnight loans between financial intermediaries”. Banks are not obligated to adhere to the cash rate, but the RBA rate has “a powerful influence on other interest rates” and “forms the base on which the structure of interest rates in the economy is built”.
In Australia, the cash rate has been at a rock bottom of 0.10% since the 2020 pandemic. Since the 2008 global financial crisis, rates have been historically low as central banks try to stimulate consumer spending and growth.
What causes rising interest?
Throughout the pandemic, central banks globally lowered rates to encourage consumer spending and credit growth to stimulate the economy. However, record low rates throughout the last two years have caused demand to outpace already stressed supply culminating in soaring inflation.
Central banks are now indicating an extension of a tighter monetary policy cycle to combat rampant inflation.
The RBA joined compatriots in New Zealand, the US, Canada and the UK in raising rates earlier this month. Investors predict multiple additional rate hikes from central banks this year.
Futures markets are currently predicting the cash rate will hit 2.65% by December 2021.
The relationship between rising interest rates and equities
As interest rates increase, so does the cost for companies to borrow money.
Whether companies borrow money from a bank via a business loan or sell fixed income products like corporate bonds to bring in cash, rising rates mean everything costs more.
Every dollar that companies use to repay debt is a dollar that the company will not count in net profits and a dollar that the company won’t pay out to shareholders in dividends.
Businesses with higher returns on capital can generally fund their operations from existing cash flows and therefore have less requirement for debt. In contrast, debt-intensive companies generally have lower returns on capital, meaning they may have inadequate cash flow to support their operations. Moreover, the insufficiency in cash flow can be exacerbated by rising inflation, which could see rises in funding costs, leases, wages etc.
To identify if a company is in an excellent position to service debt, there are several financial ratios that can be useful. One example is the interest-coverage ratio.
This ratio focuses on debt vs profitability and measures the companies’ ability to pay interest on outstanding debt. The ratio constitutes how many times the company can pay its obligations from the income the company has effectuated. The higher the interest coverage ratio, the lower the risk that the company will be unable to pay interest.
A slowing economy and consumer confidence
As central banks raise interest rates to stricture inflation, they also induce a behavioural shift in consumer sentiment to reduce spending. Therefore, the rate increase and behavioural shift are an issue for companies relying on low-interest rates, strong economic growth, and high consumer confidence.
For instance, when interest and unemployment rates are low, consumers are optimistic about the future and are willing to spend a larger amount of their hard-earned money on goods and services they desire, like dining in nice restaurants or a new couch. However, as rates and the cost-of-living rise, consumers become pessimistic and cautious about the future. Their focus has been repositioned from buying a new TV to managing their mortgage. Consumers are more likely to continue wearing the shoes they already own rather than fork out an extra $200 for the newest kicks. Consumer caution poses a threat for companies that fall in the “consumer discretionary” sector and cater to consumer wants instead of needs.
With rising interest rates, let’s apply this concept to the current economic environment.
Temple and Webster’s shares have fallen 58% this year, while Coles shares increased 5%. Overall, the consumer discretionary sector has been down 13% over the last three months, while the consumer staples sector is up 10%.
A depletion in consumer confidence can also lead to goods substitution. Goods substitution means selecting a cheaper alternative when companies produce goods or services that vary slightly but fulfil similar purposes. The preference for a less expensive option may reduce companies’ profit margins in a competitive market. For example, if consumers switch from Stan to Amazon Prime, the profits of Stan will suffer.
Rising interest – it’s not all bad news.
Interest rates rising may harm specific market sectors, but this isn’t true for all sectors. Some sectors profit from higher interest rates, such as the financial sector, in particular banks. As rates rise, bank margins become wider.
Banks can pass on cash rate increases to borrowers by raising the rate of interest on loans while simultaneously being able to fund themselves at a cheaper rate as savers rush to deposit their savings.
Banks and consumers demonstrated such behaviours earlier this month after the RBA raised the cash rate for the first time in over a decade.
Australia’s big four banks were quick to match the Reserve Bank’s cash, hiking their variable home loan rates.
Vogue Advisory Group – helping you to better understand the market
At Vogue Advisory Group, we want to help you understand what can impact your investment and why. If you have any questions regarding interest rates or equity markets, please contact us, and one of our advisors will assist you.