The Link Between Interest Rates and the Stock Market – Guidance Financial Services
Interest rates are coming down for the first time in three years. For those with a mortgage, this is welcome news, whilst those with savings are forced to consider whether their term deposits still make sense.
But what impact do interest rate moves have on stock market investments? Given most of our superannuation is invested in stock markets, and for many of us, savings outside of super too, understanding this link is a vital piece in comprehending what is going on in the world, and forming expectations for the future.
So this week we’re going to take a look at the link between interest rates and the stock market. I hope you enjoy!
Let’s begin by level setting on how and why interest rates go up and down. Central banks set interest rates as a way to achieve the mission assigned to them by government. In Australia the Reserve Bank has three statutory objectives:
- Stability of the currency
- Maintenance of full employment
- Economic prosperity and welfare of the people of Australia
Interestingly, there is nothing specifically here about managing inflation. Rather, the RBA has adopted a goal of keeping inflation between 2% and 3%, on the basis that this is consistent with their objective around stability of currency, and also contributes to the other two objectives.
Shifting interest rates up or down changes the cost of money, and that has impacts on the decisions we all make. If interest rates are high, those with a mortgage have less money to spend on discretionary items, which means businesses like cafes, restaurants, and Harvey Norman do it a bit tougher, likely cutting staff and hours, and generally slowing the economy down.
In reverse, when interest rates fall, this frees up money throughout the economy, creating more economic opportunity and prosperity.
This at least is how the theory goes, however the situation has got murky in the past decade or so as the proportion of the population that are retired and live off their savings has increased. For people in this camp, lower interest rates reduces what they can spend, so there is a live debate right now as to whether interest rate policy remains as effective as it once was.
This caveat aside, stock markets tend to react to interest rate moves on the traditional textbook assumption that lower interest rates mean more economic activity, and higher interest rates mean less economic activity.
Businesses that want to expand typically need to borrow to do so. Lower interest rates mean they can access this capital more cheaply, and that helps in making projects viable. For those businesses who already hold debt, falling interest rates drop straight to the bottom line as increased profit for shareholders. So whether it’s growth or profit that you’re seeking as an investor, falling interest rates help on both counts.
But as mentioned earlier, falling interest rates also help at the consumer level. Those with borrowings have more money available to spend. Lower interest rates also help consumption for those who would borrow to make a significant purchase such as a car for example. At a 10% interest rate, someone might decide to stick with the old bomb, but if car yards are offering finance at 2 or 3%, the decision to upgrade to something a bit shinier can be a whole lot easier to make.
The direct impact on businesses, plus the impact on consumers, mean stock markets tend to react positively to interest rate cuts on the reasonable assumption that profits will rise for shareholders.
Another impact of changing interest rates relate to the way professional fund managers such as our super funds arrive at fair valuations for stocks. They do a calculation based on the value of future cash flows, that is dividends. A key input into these calculations is the discount rate and that is determined with reference to the interest rate. Put simply, lower interest rates mean a lower discount rate, and that means future dividends are valued more highly than would be the case in a higher interest rate world. Lower interest rates then, make it easier for fund managers to justify paying higher prices for stocks.
The final link between interest rates and the stock market centres around investor behaviour. When interest rates are high, leaving your money in a risk free term deposit is pretty attractive. But as interest rates come down, this option makes less and less sense. It’s not uncommon to have bank interest rates below the rate of inflation, in which case the purchasing power of your money is diminishing across time.
As interest rates come down, cash investors look for alternatives, and the stock market is the most logical place to explore. They can put money into stocks, and if an unexpected issue arises, know that they can get that money back out within a matter of days. A portfolio with a dividend focus here in Australia is likely to produce more income than an equivalent bank deposit. The price to be paid though is volatility in the capital value. For those with a long enough time frame, this is almost certainly a positive, as provided the portfolio is appropriately diversified, it’s almost assured that the value of the holding will increase in time, boosting returns. However in the short term there is volatility, something not experienced with bank deposits, so investors need to be able to ignore short term market gyrations, and focus on the income produced, which tends to be quite stable.
Despite the sharp market drop and then recovery earlier this year, it’s been a fantastic time to be a stock market investor in recent years. Falling interest rates should be another boost for investment markets. I’m looking forward to seeing what unfolds in the years ahead.
