Interest rates and Equity Market!! What is the relation??

Over the past few years we had witnessed a number of events which caused jitters in equity markets globally, namely the Greece Debt Crisis, Brexit, China economic slowdown and Yuan devaluation, and recent surgical operation by India. But still the stock market players have night mare of US fed rate hike and its implications in Mid 2013 even the hint of that make lot of sell of in the equity market. In this post, we will find out the relationship between interest rates and equity markets and try to understand that why markets are happy when interest rates are cut and why they are nervous when interest rates are expected to rise.

As we all know, Interest is the cost paid by the borrower for using the money of the lender for a specified period of time. We borrow money to spend on something; if we don’t have to spend, we will not borrow. Therefore, when people borrow less, it means they also spend less. Let’s also understand that what is spending for me is an income for the other person by whom we are purchasing.  

For example, if borrow from a bank to buy a car, the car manufacturer get income from the sales made to us. Now lets say if interest rate for loan is high only those who are in desperate need will borrow to buy a car and as the rates falls more and more people might be interested to take a loan for purchasing a car. Hence low or high interest rates provide incentive or disincentive to borrow. Therefore, low interest rates will result in more sales for the car manufacturer, while high interest rates will result in less sales for them. When sales increase, profits and share prices of the manufacturers increases; when sales decline, profits and share prices of the manufacturers falls. The impact of interest rates are more prominent in Auto, Real Estates, consumer durables and have less impact on consumer essential items.

What applies to a consumer also applies to companies. When interest rates are low, companies will borrow more to expand their capacities, which in turn can lead to higher sales. On the other hand, when interest rates are high, the company will refrain from borrowing and spending on capex. If a company is operating at low capacity utilization, it can increase sales by simply improving its capacity utilization. But if the capacity utilization is high, the company will not be able to increase its sales, unless they add more capacity. To add more capacity, companies need more money, but if interest rates are high, then they will be hesitant in borrowing money and as a result, will give up on higher revenues and earnings. Interest rates will have an effect not just on the manufacturer but across the supply chain. If the manufacturer is producing more, it will buy more from its suppliers; if it is producing less, it will buy less from its suppliers. Interest rates also affect the distributors or dealers of the manufacturers. That is why markets react positive to news of interest rate cuts and negatively to news of interest rate increases.

Central banks around the world (including RBI) have two main concerns with respect to interest rates; the effect of interest rates on inflation and the effect on GDP growth. Both these effects are inter-connected and therefore, the central banks have to maintain a careful balance between the two. As mentioned above lower interest rates stimulate demand for goods. But this higher demand leads to higher prices. Since Inflation affects the poorest sections of the economy the most. Central banks (including our RBI) have the responsibility of protecting the weaker sections of the economy from price rise, and they do it by adjusting interest rates (the Repo Rate in case of India, the Fed Funds rate in the US).

Interest rates changes also affect behaviour of investors. Rise in interest rate causes a flight to safety, because safer fixed income investments, like Bank Fixed Deposits, Government bonds etc become more attractive investment options relative to equity. Fears of interest rate increase also cause the yield curve to flatten out; flattening yield curve increases uncertainty and with increase in uncertainty, equity investors will demand higher risk premiums (if we are taking more risks, we demand more returns). Although in this scenario investor demands higher returns, the earnings or cash-flow projections of companies don’t change; In fact it can worsen for companies in rate sensitive sectors. The mismatch in risk premium and the fair value of the company (in terms of cash flows), will lower investors demand for stocks and will, therefore, affect stock prices.

However the impact and behaviour as mentioned above is of short term and in long term there are various other factors which may have impact on interest rates and equity market. While interest rates certainly have a role in stimulating GDP growth, GDP growth is caused by higher per capita income, improved productivity, capital and man power available for production, ease of doing business etc. Higher GDP growth will inevitably result in higher inflation, for which the central bank (RBI) will have to increase interest rates, past data shows that, GDP growth can be restrained somewhat, but not reversed, by higher interest rates.

If we look at the Indian economy, from 1996 till 2004 (See the chart below) interest rates fallen significantly but there was hardly any movement in equity market. In the early and mid-2000s, right up to 2008, equity market went up by four times and we had high GDP growth however interest rates were also rising during this period. In 2008 post Lehman crisis market fell down steeply and recovered half of it in a year after that till 2013 both equity market and interest rates were almost stagnant. Now since 2014 interest rates have fallen and equity market has gone up during the period. 

Since March 2016 the equity market has recovered considerably. However there are serious concerns about interest rates globally, especially in the US which may start hiking the fed rates post US elections. But it may have a short term impact on equities, by reducing liquidity available for equities. From a longer term perspective, increase in US interest rates means US economy is strengthening and does not need the monetary stimulus. As US the biggest and consumer driven economy, its growth will lead to demand from emerging economies like India. Further higher income to US companies will also lead to more investment in emerging markets like ours. Hence it may not be such a bad news for long term equity investors; on the contrary it is good news.