What higher interest rates could mean for stocks

Central banks around the world are responding to rising inflation by hiking interest rates at the fastest pace in recent memory.

Broadly speaking, this is bad news for investors.

The point of raising rates is to convince consumers to spend less and save more. As spending falls, companies should start to cut prices in an effort to win a greater share of consumers’ reduced spending power.

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Higher rates are also pushing up the cost of borrowing. That could force both businesses and consumers to delay spending plans, putting pressure on suppliers to lower prices to try and keep market share.

Higher interest rates will hurt demand

The whole point of higher interest rates is to lower demand for goods and services – and that’s never good news for business.

A company that earns less is worth less; investors are going to have to factor this into their calculations.

However, reduced supply isn’t the only thing investors have to worry about. Higher interest rates also mean more expensive borrowing.

In the UK, the markets are now predicting that the Bank of England will raise interest rates to 5% or more next year as it tries to bring inflation under control. Government bonds (or gilts) have sold off to reflect these projections (bond prices fall as yields rise). The government is now paying more than 4% to borrow money for ten years, whereas only 12 months ago the rate was a little over 1%.

As most financial products are priced based on gilt rates, this has had a huge impact on the UK financial system. It has affected every part of the economy, from business borrowing to mortgages and credit cards.

This is bad news for companies that carry a lot of debt. The interest rate investors are demanding from businesses who want to borrow money has jumped to levels not seen since before the financial crisis. The average yield on a portfolio of high-grade corporate bonds – think blue-chip companies – recently hit 6.7%. Meanwhile, costs for distressed borrowers are in the double digits.

Based on the value of its outstanding bonds in the market, if retailer Iceland wanted to borrow money today, it would have to pay nearly 17% a year! To put that figure into perspective the interest rate on my Barclaycard credit card is 19.2% on purchases.

So, higher interest rates could hit business sales (the top line) and incur higher borrowing costs (the bottom line). And that’s without taking into account the other headwinds that come from inflation such as higher labour costs (these will also put pressure on profit margins).

Stocks could fall as valuations are revised

As well as these fundamental business challenges, there’s another factor investors need to be aware of: discount rates.

There are many different methods investors can use to try and value equities, but one of the most common is called the discount cash flow method. In its most basic form, this calculator is used to try and estimate how much a company could be worth today based on future cash generation.

There’s a lot of guesswork that goes into these calculations, so they are a bit hit and miss. Nevertheless, it’s a favourite tool of analysts and investors around the world.

To calculate the figure, analysts take the projected future cash flows from a business and discount them back to the present using interest rates of their choice. The rate is designed to compensate investors for the risk they’re taking when investing. This is usually based on the so-called risk-free rate, the US ten-year Treasury yield.

The calculation is based on the concept of the “time value of money”, that is the money you’re promised in the future is worth less than cash received today because you can invest today’s money for future growth. To put it another way, when investing in an asset you’re paying for the right to receive money in the future, so you need to have some idea of what it’s worth today.

Now, the discount cash flow analysis is very sensitive both to cash-flow estimates and the discount rate applied. The lower the discount rate, the higher the present value of future cash flows. On the other hand, the higher the rate, the lower the value of future cash flows.

So, if interest rates are rising around the world, investors won’t want to pay as much for equities as they might have been willing to pay a year ago when rates were lower. Coupled with the threat of falling sales and rising costs, this is a bit of a toxic combination for equities.