Interest Rate in simple words means the cost of borrowing funds. We all know that interest rate & bond prices are inversely related. Even stock market performance is linked to interest rate. Let’s explore the relation between interest rate and stock market performance through different perspectives.
Firstly we look at the Liquidity Perspective. With the rise in interest rate, deposits in the bank increases which sucks up the supply of money in the economy. This usually lowers the liquidity. Now, lower liquidity leads to:
-Lower consumption (because of higher savings and lower disposable income of the households);
-Lower investment (due to higher cost of borrowing towards expansion plans and thus deferred)
-Lower speculation (it becomes expensive to borrow and speculate in stock market now)
All this in turn has a negative impact on stock prices.
Let us now evaluate the Valuation Perspective. Higher the interest rates, higher will be the required rate of return for equity investors – since they require a premium over and above the risk free rates to compensate for the additional risk associated with investing in equity. This implies that a higher discount rate shall be used for valuing the business through methods like DCF, NPV, etc. This in turn shall affect the valuation of a business negatively as their discounted cash flows will reduce in value.
Next, we analyze the Earnings Perspective. Increase in interest reduces the profitability of the company and thus will lower its ability to declare higher dividends. Lower dividends again translate into lower stock valuation as methods like dividend forecast approach, earnings price ratio approach discount the expected dividends to arrive at a fair value of equity.
As seen above, interest rate and stock prices are inversely related. In a high interest rate scenario, companies with zero or near zero debts in their balance sheets are better off. FMCG or fast moving consumer goods is one sector that’s considered as a defensive sector due to its low debt nature. Whereas the Capital intensive industries like automobiles, real estate etc would be most affected by high interest rate. Prices of stock depend on many factors; interest rates are merely one of the numerous such factors.