The movement of interest rates is something many stock market investors watch keenly – just look at the amount of commentary on the Federal Reserve’s stance on rates. But, if you invest in stocks, should you really be paying attention to interest rates? Here are three things you need to know.
First, the reality behind interest rate movements and stock prices…
Theory holds that stocks and other asset classes – such as bonds, cash, and real estate – are constantly fighting for investors’ capital. When interest rates are high, investors have lesser interest in stocks as the alternative (bonds) can produce a good return. But, when interest rates are low, investors are keen to bid up stocks since the alternative (again, bonds) can’t generate a decent return.
With this framework, rising interest rates are not good for stock prices. But that’s theory. Reality’s a different picture.
Robert Shiller, a professor of economics and the winner of a Nobel Prize in economics in 2013, has an amazing repository of long-term US stock market data – going back all the way to the 1870s – that he has made available for free.
His data contains a fascinating chart showing the changes of long-term interest rates in the US together with the valuations of US stocks. Shiller’s data uses the S&P 500 index as a representation for US stocks and the cyclically adjusted price earnings (CAPE) ratio as the valuation measure. I’ve recreated a portion of the chart for the period from 1920 to October 2018, which you can see below:
Source: Robert Shiller
There was a 30-plus year period starting from the early 1930s that saw rising interest rates coincide with rising valuations. It was only in the early 1980s when falling interest rates were met with rising valuations. For me, the chart above is a great example of how changes in interest rates can’t tell us much (if anything at all) about the movement of stocks. In fact, relationships in the world of finance are seldom clear-cut. “If A happens, then B will occur” is something that is found rarely.
So, rising interest rates alone will not necessarily hurt your portfolio of stocks by depressing valuations. This is important to note because after keeping interest rates in the US near zero for years in order to deal with the aftermath of the Global Financial Crisis of 2008 and 2009, the Federal Reserve – the US’s central bank – started raising rates at the end of 2015. Since then, the Fed has hiked rates a total of eight times. Although, worries over the economy has made the Fed a lot more reluctant to hike rates now.
… Second, interest rates have historically fallen as a country develops…
Investor Josh Brown recently recounted a dinner he had with investment writer and thinker, Willam Bernstein, earlier this year. During the dinner, Bernstein shared a question that he had been thinking about for some time: What if the cost of capital (in other words, interest rates) never rises again?
It is an important topic to ponder because when we look back in time, interest rates have fallen as a country or civilisation develops and matures. Here’s Bernstein writing on the topic in his great book, The Birth of Plenty:
“Interest rates, according to economic historian Richard Sylla, accurately reflect a society’s health. In effect, a plot of interest rates over time is a nation’s “fever curve.” In uncertain times rates rise because there is less sense of public security and trust. Over the broad sweep of history, all of the major ancient civilisations demonstrated a “U-shaped” pattern of interest rates. There were high rates early in their history, following by slowly falling rates as the civilisations matured and stabilized. This led to low rates at the height of their development, and, finally, as the civilisations decayed, there was a return of rising rates.”
With this backdrop, it is possible that interest rates in the US – and by extension, Singapore, since our local interest rates are influenced by what happens in the US – could stay low for a very long period of time.
…Third, what should investors keep in mind
When we put together Shiller’s graph and Bernstein’s data on how interest rates change with the growth of civilisations, I have two thoughts.
One, rising interest rates may not hurt our stock market portfolios by depressing the valuations of our stocks. But, higher rates could still 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 costs of borrowing rises too. It’s all the more dangerous for heavily leveraged companies that already have difficulty in generating positive operating cash flow at the moment.
With this in mind, 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 shareholders’ 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. The five companies with the highest market capitalisations that passed through my screen are Oxley Holdings Ltd (SGX: 5UX), Maxi-Cash Financial Services Corp Ltd (SGX: 5UF), TA Corporation Ltd (SGX: PA3), Pacific Star Development Ltd (SGX: 1C5), and Samko Timber Ltd (SGX: E6R). 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 if interest rates rise.
Source: S&P Global Market Intelligence (data as of 17 June 2019)
Second, no one really knows where interest rates will end up. In fact, history has shown us that interest rates tend to fall as a country grows in strength and matures. The implications of a world that is awash with cheap credit is fascinating. In certain ways, Japan has already been in a situation like this for decades.
10-year Japanese government bonds have never exceeded a 2% yield going back to the fourth quarter of 2017, according to data from the Federal Reserve Bank of St Louis, and in fact, has fallen from 1.96% to a negative 0.04% in the first quarter of this year. Interestingly, the Nikkei 225 index – Japan’s main stock market index – has barely budged from October 1997 to today, despite low and falling interest rates in the country. Yet, there’s a company in the country like Fast Retailing – owner of the Uniqlo clothing brand – which has seen its stock price increase by over 10,800% over the same time frame because of massive growth in its business. From the year ended 31 August 1998 (FY1998) to FY2018, Fast Retailing’s revenue and profit have increased by 25 times and 53 times, respectively.
The bottom line
So, the key themes from everything seen earlier in this article are:
1. Rising interest rates may not hurt our stock market portfolios by depressing the valuations of our stocks;
2. But higher interest rates could still hurt stocks with businesses that are heavily in debt and have trouble generating cash;
3. Falling interest rates need not necessarily benefit stocks, as seen in Japan’s case; and
4. Individual stocks can still be huge winners even in a flat market, if their businesses do well.
And what does all these mean for you, if you invest in stocks? Don’t bother with interest rates – focus on the health and growth of the businesses that are behind the stocks.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing does not own shares in any companies mentioned.