Impact of High-Interest Rates on Stock Market and Individual Stocks

The Indian stock market has experienced a severe decline ever since the RBI raised the repo rate by 40 basis points and the cash reserve ratio by 50 basis points.

To tackle excessive inflation in their economies, central banks around the world are raising interest rates.

How does it work?

When the RBI lends banks short-term funding, the rate is called the repo rate. Therefore, a rate increase essentially raises the cost of borrowing for banks. Banks charge their clients greater coupon rates on their borrowings as a way of passing along these additional costs.

Consumers have less disposable income since they have higher EMIs to pay on their loans. Businesses that depend on consumer disposable income see a decline in revenues and profitability as a result of decreased consumer spending when consumers have less of it. To adapt to the new reality, businesses also stop hiring new employees or cut back on their personnel, which again has an impact on household budgets.

Therefore, central banks try to control prices by raising interest rates by reducing excessive demand.

How does it affect the stock market?

In general, corporate earnings determine how the stock market performs. Therefore, the stock market will benefit more from an increase in company profits and expectations.

Stocks that are sensitive to changes in interest rates typically see greater declines. For instance, a residential real estate development company sees a decline in demand as a result of increasing house mortgage EMIs. Naturally, this has an impact on the business’s profitability.

Other interest-rate-sensitive industries include banking and finance, automobiles, real estate, and consumer durables.

On the other side, some companies frequently experience success whenever interest rates increase. As an illustration, consider the insurance industry. Rate increases have the potential to stabilise cash flows and raise risk premiums for conventional goods. Among the other robust equities are those in technology, pharmaceuticals, and energy.

In addition, the stock market won’t respond to a rate increase if nothing bad happens to customers or businesses. In anticipation of a reduction or increase in interest rates, the market typically moves upward or downward. Or if the RBI action does not match expectations.

Investing in a rising interest rate regime is not always bad

The economy has ups and downs in cycles. Additionally, inflation is a fact of life. Therefore, anytime inflation spikes, the RBI will continue to raise interest rates and vice versa.

Be prepared to see the company’s earnings and revenues decline temporarily. But as the economy stabilises and inflation returns to normal levels, demand will go up again. And the stock market tends to rise at that time.

To put it simply, to get the most out of stocks, maintain the intended asset allocation and have a long-term perspective.

Check the BEER

The tactical allocation that flows toward bonds and the stock market is also impacted by changes in interest rates. Simply explained, as interest rates rise, bond yields likewise rise. Bond yield is calculated by dividing interest payments received by the bond’s market value. Furthermore, the benchmark yield on 10-year government bonds is currently 7.3% annualised.

Earnings Yield is calculated by dividing the index’s earnings per share by the stock’s index price. It displays the EPS returns produced by the companies that make up an index’s constituents. It can alternatively be calculated as the PE ratio’s inverse. For instance, the earnings yield is (1/22*100) 4.5% if the PE ratio of the Sensex is 22.

Bond yields and earnings yield (of the stock index) have a theoretical relationship.

The Relationship

When bond yields exceed earnings yield, there are frequently strategic short-term money flows from equity into bonds and vice versa.

Before switching, these investors frequently search for a favourable spread. It has been observed in the past that anytime the BEER ratio, calculated as Bond yields divided by Index earnings yields, is less than 0.75 or greater than 1.25, action and reallocation are prompted.

Additionally, the BEER ratio is currently 0.61, which is too low to prevent strategic portfolio reallocations in favour of debt.

Long-term stock market investors, however, need not be concerned about tactical portfolio adjustments and momentary market corrections brought on by an environment of rising interest rates. When consumer demand picks up again and business earnings reflect it, losses will eventually be recovered.