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How do interest rates affect stocks? That’s a question that is particularly pertinent with interest rates being hiked at the fastest pace in decades.
Clearly, interest rates do affect stocks – otherwise, there wouldn’t have been a ‘Tech Wreck’. But just why are they such a big factor?
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How do interest rates affect stocks?
1. Interest rates influence the appeal of equities as compared to other assets
When interest rates are low, investors are more likely to invest their capital in stocks because there is less reward available from other investments such as bonds and cash. Low interest rates make stock investing attractive due to the potential for higher returns.
However, when rates increase, stocks may become less attractive to investors since they offer comparatively lower returns. Of course, there will always be stocks that go up when interest rates are higher and those that go down when interest rates are lower.
But when rates rise as fast as they have, equities as an asset class generally are less appealing. Granted there are exemptions such as electricity providers and lithium miners and developers.
2. Interest rates impact debt levels
High interest rates inevitably lead to higher borrowing costs which inevitably reduce profits through decreased consumer demand for the company’s goods or services.
And if the company has individual debt, they too will have to pay more for their borrowings – both principal and interest.
3. Interest rates impact the valuation of stocks…
…given the two aforementioned factors and given that certain methods to value stocks depend on interest rates.
One common method is the Discounted Cash Flow (DCF) formula. It assumes a company is worth the sum of its future cash flows, discounted back to the present given the time value of money (it assumes that a dollar that you have in the future is worth less than a dollar today it cannot be invested).
When interest rates are higher, the discount rate ascribed to future cash flows is high and the valuation of companies is smaller.
Turning to the multiples method of valuing companies, these may fall too if a company’s earnings fall.
Why are tech companies impacted more than other companies?
Tech stocks have been hit harder by recent interest rate rises than other sectors due to their reliance on inexpensive debt and low-cost capital.
These stocks tend to benefit from low-interest rates, as the cost of capital for tech firms is typically lower than other sectors.
When rates rise, tech companies must pay more in interest on existing debt and find it more difficult to access new funds at low rates, significantly reducing their profits.
Additionally, higher rates also weigh heavily on consumer spending, which can hurt demand for many tech products.
Finally, higher borrowing costs make it more challenging for tech firms to finance expansion initiatives, hindering their growth prospects.
It’s not the case that there are specific factors that only apply to tech stocks, but the same factors that apply to other sectors apply moreso.
What sectors are less impacted?
Consumer staples companies often have lower levels of debt than other sectors, allowing them to largely remain unaffected by higher financing costs. And by definition, they are not discretionary – consumers cannot just cut back their spending while maintaining the same quality of life.
Healthcare firms also tend to be less sensitive to interest rate fluctuations due their stable business models, long-term contracts with insurers and government payers and reliance of their customers on them.
It is important to note that we’re specifically talking about those that have commercialised goods into the market, not those that are still in the clinical trial stage – clinical trials have to be financed somehow.
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