Impact of Interest Rates on Stock Valuations

Stock Valuations
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Interest rates are an important catalyst to stock market cycles as interest rates impact both the topline and the bottomline of corporate. The immediate impact is on bottomlines as interest costs reduce / increase while the topline gets impacted as higher interest rates curtail demand while lower interest rates spur it.

Topline Impact 

There are sectors though that are more sensitive to interest rates while there are some that are relatively agnostic to it. E.g. Companies in the FMCG, IT and Pharma typically are less sensitive to interest rates ( As some of these sectors or companies have inelastic demand which implies that their products’ demand don’t necessarily decrease with an increase in prices e.g. Cigarettes , Alcohol or even household items like food etc)

Bottomline Impact 

Conversely there are sectors that have an immediate impact due to rising interest rates like banking and nbc’s where they are impacted by treasury losses on their bond portfolios ( Since bond prices have an inverse relationship with interest rates i.e. Bond Prices move down if interest rates go up) and also demand for credit reduces with higher interest rates, their net interest margins also can get impacted in the short run. Even companies in the capital goods and infrastructure space get impacted as corporates reduce or withhold spending on additional capex in a high interest rate regime. Bottomlines can also get impacted as the raw materials they use for making their product, rise in prices and due to a competitive market environment they are unable to pass on the entire price hike to the consumer. Interest rates rise a lot of times in India due to rise in oil prices which in turn creates higher inflation and leading to higher interest rates , this impacts companies that have oil as a raw material – Airline companies are directly impacted while there are several other companies that have oil or oil products that are part of their raw material.

Flight of Capital

Lastly as interest rates rise, there is a flight of capital that also happens from investors into fixed income as an asset class from equities. E.g. If interest rates are 6%, the tendency for investors to lock in money at those yields is low and hence equities tempt them, however when interest rates are north of 8% investors might be more willing to park funds into fixed income securities like bonds, Fixed Deposits etc.

Valuation of companies also get impacted due to interest rates as investors tend to assign a lower multiple to companies in a low interest rate scenario ( since their is more visibility of growth reduces plus the opportunity cost of their funds ( as discussed above the return on a fixed income instrument) increases and hence demand for equities reduce)

Mutual Fund Investors 

Investors in mutual funds should continue and stick to their investment objective and short term gyrations in financial markets should not deter those long term goals. Investors who are risk averse should while designing their investment policies or goals, include a strategy that helps them rebalance their portfolio between debt and equity ( I.e. A strategy where for example if you have Rs. 50 in equities and Rs. 50 in debt, and over time as you see the equity portfolio move higher due to a rise in equity markets move out of equities partially i.e. if it becomes Rs. 55 you sell the additional equity amount to bring the portfolio allocation back to a 50:50 level) This strategy enables one to sell at a higher point and buy at a lower point. However it has to be noted that this is a conservative strategy for achieving lower volatility as over long periods it is likely that a buy and hold strategy with low costs would yield better returns Vs a balancing strategy since equities would always have a fair delta over fixed income over long periods, albeit with higher volatility.

Also from a sector perspective investors should be more worried on choosing schemes / funds / managers that have a good track record and entrust them with juggling between the sectors as they deem fit. Investors should not realign strategies due to short term market gyrations as volatility is and will always be an inherent aspect of equity markets.

For direct equity investors, multiple factors need to be assessed before taking a decision. For risk averse investors, their portfolio could move to a more defensive portfolio, however at the same time they need to assess whether the companies they hold in would a) Have any material impact on their toplines ( example NBFC’s or housing finance companies) due to rise in interest rates and bottomlines ( Firstly, Whether they are debt heavy and an increase in interest rates impact their profits- companies with a low debt / debt free balance sheet can do very well in such times, secondly also they need to assess whether the companies they hold have raw materials whose prices increase and since they can’t pass on the price rise to the customer, their profitability takes a hit – airline companies for example are unable to pass the entire rise in oil prices to the consumer due to a competitive market environment)

About the Author:

Mr. Vivek Banka, Founder of Altiore Capital financial services veteran,  with a career spanning almost 2 decades with firms like IIFL Wealth Management (2010 – 2016), BNP Paribas (2005 – 2010) etc.