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Will Rising Interest Rates Hurt Your Portfolio?

It appears that rising interest rates are weighing heavily on many investors’ minds at the moment. In light of the recent stock market sell-off, CNBC cited “fears of rapidly rising interest rates” as a reason, while BBC said there were “concerns about rising interest rates.”

So should you, as a stock market investor, fear climbing interest rates? Will higher interest rates hurt your portfolio? I’ll like to address these questions in this article.

The state with interest rates now

The Federal Funds Rate is the interest rate that banks charge to lend reserves (funds held at the Federal Reserve) to each other overnight. It is also the interest rate that the Federal Reserve, the US’s central bank, primarily influences.

After keeping the Federal Funds Rate at near zero for years in order to deal with the aftermath of the Global Financial Crisis of 2008 and 2009, the Fed started raising rates at the end of 2015. Since then, the Fed has continued to hike the Federal Funds Rate. It did so three times in 2017, and thrice so far in 2018.

The Fed has signalled one more rate hike for the rest of 2018, and three hikes for 2019. The US’s central bank does not have total control over interest rates, but it’s likely that interest rates will be moving higher in the years ahead.

How interest rates and share prices move, in theory

Theory holds that stocks and other asset classes – such as bonds, cash, and real estate – are in a constant jostle for investors’ capital. When interest rates are high, investors shouldn’t pay up for stocks as the alternative (bonds) can deliver a good return. On the other hand, when rates are low, it makes sense to bid up stocks since the alternative (again, bonds) are not capable of generating a decent return.

What the theory also means is that rising interest rates are not good for stock prices. But, what has historical data showed us? Let’s take a look.

How interest rates and share prices have actually moved

Economics professor and 2013 Nobel Prize winner Robert Shiller has an amazing repository of long-term U.S. stock market data, going back all the way to the 1870s, that he has made available for free to all.

Within his data-set is an interesting chart which plots the movement of US long-term interest rates with valuations of US stocks; Shiller’s data uses the S&P 500 index as a representation of US stocks and the cyclically adjusted price earnings (CAPE) ratio as the valuation measure. I’ve recreated a part of his chart for the period from 1920 to today, which you can see below:

Source: Robert Shiller

Beginning from the early 1930s, there was a good three decades-plus period when rising interest rates coincided with rising valuations. It was only in the early 1980s when falling interest rates were met with rising valuations. For me, this chart is a great example of how changes in interest rates can’t tell us much (if anything at all) about the movement of stocks.

Relationships in the world of finance are not always as clear-cut as we’d like them to be. Single variable analysis – where you go “if A, then B” – fail more often than they work. The chart above is a great example.

So, rising interest rates alone will not necessarily hurt your portfolio of stocks by depressing valuations.

What to watch

Instead, the focus should be on the businesses of the stocks you own. Ultimately, it is the performance of a company’s business which drives its share price over the long-term.

And on that note, higher interest rates may hurt us if our portfolios are full of companies that have borrowed heavily – such companies may suffer in a period of rising interest rates because their cost of borrowing rises too.

It’s all the more dangerous for heavily leveraged companies that have: (1) floating interest rates for a significant portion of their borrowings; and/or (2) difficulty in generating positive operating cash flow at the moment.

It’s hard to screen for details on companies’ debt, such as whether the borrowings are on floating or fixed-rates. But, it’s easy to construct a screen that can sieve out companies with heavy debt loads and a weak ability to generate cash from their businesses; these are the companies that are facing significant risks from rising interest rates.

So, I ran a screen on S&P Global Market Intelligence for Singapore-listed companies to find those that meet both of the following criteria: (1) A net debt to equity ratio of more than 200% currently, where net debt refers to total borrowings less total cash & short-term investments; and (2) negative operating cash flow over the last 12 months.

Here are the five companies with the highest market capitalisations that passed through my screen: Aspial Corporation (SGX: A30), Vard Holdings Ltd (SGX: MS7), World Class Global Ltd (SGX: 1E6), OUE Lippo Healthcare (SGX: 5WA), and Excelpoint Technology (SGX: BDF).

Source: S&P Global Market Intelligence (data as of 11 October 2018)

The quintet may not necessarily be bad investments going forward. But if you have any of them in your portfolio, you may want to watch them closely. Their businesses could be hurt in the future.

The types of companies to invest in

Be it an era of rising or falling interest rates, I think the shares of companies that have healthy balance sheets (more cash than debt), a strong ability to generate cash flow, and powerful long-term tailwinds, are the best kind of investments for our portfolios.

An earlier version of this article was first published in the 19 October 2018 edition of Take Stock Singapore, The Motley Fool Singapore’s free investing newsletter.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore writer Chong Ser Jing does not own shares in any companies mentioned.