What higher interest rates mean for equities

By Cutcher & Neale Accounting and Financial Services - February 15, 2022

Expectations for 2022 to be more volatile and difficult than 2021 from an equity investors perspective is certainly playing out.

Inflation fears and impending tighter monetary policy are weighing on share prices as are tensions between Russia and the Ukraine. Government bond yields that have been declining for 40 years are now indicating this trend is about to change which is further bad news for stocks for three main reasons.

Firstly, investors choice between stocks and bonds are in competition for allocation of their assets. If bonds are yielding higher this will cause investors to switch out of equities. Secondly, higher bond yields increase the costs of corporates to raise finance making it harder for companies and the economy to grow.

Thirdly, and making the greatest impact already are equity valuations. The future value of expected profits needs to be discounted to take into account the effect of “time value of money”. Simply put, a dollar in your hand today is worth more than in ten years’ time in the future. The discount rate, also known as the “risk-free rate of return” usually compares benchmark government bond yields to strip out the cost of what could be earned elsewhere. Government bonds are not without any risk, certainly not for some nations however if we think of Australian government bonds or US treasury’s, they sit just above cash at a bank on the risk spectrum.

The lower the comparative bond yield, the lower the discount rate and the higher the company’s valuation. Of course, if those bond yields rise than this increases the discount rate and company valuations drop. The current Australian and US benchmark 10-year treasury yield has surged from the March 2020 low (0.75% and 0.52% respectively) trading around ~2%, the highest yield since January 2020, pre-pandemic.

The current lofty equity valuations based on decades long low bond yields is perhaps the greatest threat for stock markets. While interest rates where low and stable, high growth stocks justified elevated multiples and valuations. The threat of higher interest rates exposes companies to any kind of earnings miss, Meta/Facebook recorded the biggest one day drop in value in the history of the US stock market after weaker than expected revenue forecast in February, providing a cautionary tale.

Central banks such as the RBA and US Federal Reserve are now almost certain to raise interest rates and begin the process of balance sheet contraction in 2022 – the question is when and how fast? For equities most portfolios have naturally become overweight to large-cap growth company’s such as the US mega-tech’s over the course of the last 2 years. Investors may benefit from diversifying into areas of the market that are under-owned, relatively less expensive and have historically outperformed under these conditions.

If you’d like to have a chat about what’s right for you get in touch with our Wealth Management team.

 

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