How Interest Rate Impacts Stocks

Date: 07-03-2017
Views: 1103

How do interest rates impact stocks and stock prices? How does rise or fall in interest rates affect stocks? Here's a simple explanation.

UDAYAN RAY Well, interest rates are not just important for fixed deposits (FD) which you would probably invest in a bank fixed deposit or any other company fixed deposits, or your loans. They actually impact your stock market investments as well. How? Well, to give you the answer we have with us stock market expert Mohit Satyanand.

Hi Mohit!

MOHIT SATYANAND Hi Udayan !

UDAYAN RAY Normally, a person would associate interest rates with things like a loan such as a home loan or car loan or other retail loans, or say, a fixed deposit. How does it enter into a stock market or stocks investing?

MOHIT SATYANAND Well, primarily in two ways. The first is that we all have a limited amount of money to invest. And you can think of various places in which to put the money. So you are looking at interest rate as a way of signaling the price of money or the opportunity cost of that money.

Let’s say I have only two options on what to do with my money. One is to put it in the bank and earn an interest rate and a fixed deposit, and the other is to put it in the stock markets. Now, obviously the higher the interest rate that the bank is giving, the more attractive that is going to be. And relatively less attractive it is going to be for me to invest in stocks. Broadly speaking, though the connection is not so tight or so sharp, the higher interest rates are the less attractive stock markets are.

The other is via the cost of funds for company. Most companies are net borrowers. They borrow money from banks or other financial institutions in order to run their operations. And the cost of that borrowing is interest rate. And obviously, when they pay that money out that becomes a cost to that company, and it reduces profits. So the higher interest rates are, all other things remaining equal, which of course they never do, the lower the profits in the company. So again broadly speaking, if interest rates are lower, companies can make somewhat higher profits. And therefore, in general you could say that higher the interest rates are, it is bad for the stock markets from both these perspectives. The opportunity cost of your money as well as the profitability of companies with lower interest rates are good. But it’s not actually as simple as that. And if I were to be asked a question, are interest rates a very important determinant of whether one should invest in stock markets or not, I would tend towards saying that it not very important.

UDAYAN RAY Mohit, you can do a marathon and I can’t even run a kilometer. Are there certain stocks which tend to be a little more vulnerable i.e. more impacted by what’s going on in terms of interest rates?

MOHIT SATYANAND Yes. There are what we call interest rate sensitive stocks. And the irony of course is that they become much more sensitive to interest rates after a boom period.

Okay? So they go through a period when they think the interest rate is not so important, the economy is expanding so fast that a little bit of extra cost of borrowing doesn’t matter. So they keep growing and growing. And then, there’s a bust after the boom.

This is what we have seen time and time again. We saw it in 2007-2008. Suddenly, the cost of servicing their loans becomes larger, accounting for larger and larger percentage of earnings. And then earnings are not going up because they are not making any fresh investments. There’s too much capacity in the economy whether it’s power or real estate or other infrastructure. So now how do they increase their profitability? Or, how do they reduce their losses? Often we are talking about reduction of losses, not an increase in profitability. The only way is that the cost of their borrowing goes down. And then, they become not just interest rate sensitive but interest rate hyper sensitive stocks. But I don’t think you should be owning those stocks in the first place.

UDAYAN RAY Well, that clarifies quite a few things. I would take a liberty of taking one step ahead of what Mohit just said. For companies, it’s almost like your pay is remaining the same but your EMI is going up; your loan instalments are going up.

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