Last year Americans watched inflation hit a 40 year high. The Fed responded with a series of interest rate hikes, each of which had a direct impact on the stock market. To make intelligent investment decisions in 2023, it helps to understand why and how rising interest rates impact the market. Here are a few insights:
The Cost of Borrowing
When interest rates go up, it means that borrowing money is more expensive. When it is more expensive to borrow money, it takes away from the profits of businesses which affects the stock price. High interest rates also mean that investors have more lucrative options for investing their money other than stocks, so they may put their money elsewhere, further affecting stock prices.
How Interest Affects Asset Classes
These interest rate hikes affect some asset classes more than others. For example, banking and financial services tend to slow down borrowing by businesses, consumers, and investors. This can negatively impact demand in this sector. Rising interest rates also impact the housing market because mortgages become more expensive which tends to reduce demand in the housing market. Car loans and leases become more expensive with higher interest rates, reducing demand for cars and other automobiles. Rising interest rates make it harder for businesses to finance construction projects, leading to slower activity in this sector. Retailers may be affected by higher interest rates as consumers may choose to save or pay down debt rather than spend on discretionary items. Even the manufacturing industry is affected because they may find it more difficult to acquire loans at higher interest rates, resulting in reduced investment and activity.
Tech Takes a Hit
One of the sectors to get hit the hardest by interest hikes was Tech. The 40 year inflation high was one of the reasons why the wind was knocked out of mega caps like Meta, Netflix, Apple, Alphabet (Google), and other FAANG stocks causing them to plummet. When interest rates rise, stocks with high price-earnings ratios and fast growing companies like technology sticks tend to fall quicker than stocks with lower price-earnings ratios because investors become less willing to pay a higher price for stocks’ future growth when returns on bonds are higher. Investors are also more likely to favor bonds over stocks when rates rise, causing stock prices to drop. The hope of fast future growth gets discounted quickly when there are less risky alternatives available coupled with anticipated economic slowing which usually impacts and creates uncertainty for the faster growing companies causing investors to want to take less risk.
Higher Costs, Reduced Spending, and Consumer Psychology
Inflation and rising interest rates go hand in glove with each other. As interest rates create various market pressures, so too inflation results in increased costs for companies. Similarly, consumers tend to tighten their belts. The result is that any slowdown in potential earning growth of a fast growing company has a magnified impact on today’s values. Rising interest tends to impact investors’ psychology causing both consumers and investors to cut back on spending. The result is that stocks fall, earnings diminish, and the market drops.
The Impact on Growth Stocks and the Time Value of Money
Growth stocks respond negatively to interest rate hikes because the value of future earnings drops relative to the dollar today. Think of it in terms of the time value of money, an economic concept that explains the difference between present vand future value of money. A given amount of money today is worth more than the same amount in the future due to its potential earnings capacity. For example, if you have $100 today and invest it for one year at an interest rate of 5%, then at the end of the year, you would have $105. Thus, the time value of money states that $100 today is worth more than $105 in one year’s time.
Imagine you have a company that expects to grow 40% next year. $100 today is worth $140 next year. Now imagine that there’s a risk that they may only grow by 20% instead of the desired 40%. In this scenario, the same $100 is only worth $120 next year not the $140. Now imagine that we were building our model on a grand 40% for five years, but it only grows 20% for those five years. Now the value of the stock that we thought today was worth $300 because of the massive growth it was going to experience over the next five years will only be worth $80 simply because of the time value of money and the amount of risk we are taking to get bigger returns.