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Rising interest rates and their impact on stock markets

Conventional wisdom suggests that increasing interest rates are bad news for stock markets. Financing costs go up for companies, impacting profits negatively. And the opportunity cost goes up for buyers of stocks – the alternative of buying bonds becomes more attractive as their yields increase.

So, we have two questions at hand: Are interest rates going to rise? And if so, should you avoid stocks?

Question number 1: Should we expect higher interest rates? Well, they can’t fall much further; and economic growth is currently pretty healthy worldwide, allowing central banks to be a little less generous with providing “cheap” money. That doesn’t mean we have to see a spike in interest rates any time soon. Indeed, I don’t expect that. As central banks try to balance between the risk of inflation (fuelled by too easy money) and choking debt laden companies and countries (by raising interest rates too quickly), they plan to be careful, not increasing rates aggressively. And that seems perfectly justified given that inflation rates are stubbornly low across the developed economies despite increasing growth rates.

But longer term: Yes, I would expect higher interest rates. Not many people would characterize negative short term interest rates as the “new normal” or as sustainable; eventually inflation may well increase (we already see quite significant shortages on a number of labour markets – and where those jobs allow profitable growth, companies will be willing to pay higher salaries); and at some point most of the money the central banks are now pumping into the bond markets will have to come out again.

On that basis, I expect interest rates to go up over the coming years, without a drastic increase any time soon. Take the interest rates set by the European Central Bank – some experts think they may reach 2% by end 2022. That is 5 years away, and 2% is not a high interest rate. Yields of longer term bonds could go up a bit faster, though. And the US seem to be ahead of Europe in that cycle.

Okay then, question 2: What does that mean for stocks?

Firstly, the increase in interest rates is driven by an (expected and partially observable) return of inflation. The (currently still low) inflation is driven by higher demand for goods and labour. In other words, by higher income. To simplify a bit: Interest rates go up as profits go up. And we all like stocks when profits go up. Now, you may ask whether we could see that in the past: What can we learn from statistics – have stocks suffered from increased interest rates? Well, the correlation is actually weaker than you may think, and the reaction of stock markets depends on lots of circumstances. Take the 1970’s and 80’s – higher interest rates also mirrored higher inflation then, but inflation was driven by increasing energy prices, and growth was very sluggish. Since then we have not seen interest rates rise over a prolonged period of time, and the data to compare with is quite “aged”.

So let’s just say that fundamentally it’s a mixed bag. Higher interest in itself is not a good thing, but if it comes with higher profits, stock prices can still go up.

Secondly, investors always look for the best investment alternatives. And even if interest rates are starting to increase, it will take a long time before short term bonds reach interest levels many solid stocks offer as dividend yields. What about longer term bonds, then? Well, their prices will come down as interest levels go up (because instead of the older bonds with lower nominal interest, investors can now buy new emissions with higher yields – so the old ones have to fall in price to match the new ones). That is important: Neither short term nor long term bonds look like an attractive investment alternative to stocks for years to come – quite different to the experience for most of the last 30 years. Other alternatives? Property prices also have gone up a lot, and rising interest rates make mortgages more expensive and can even lead to forced sales; the gold price typically suffers from higher interest rates because gold doesn’t offer any ongoing income; … you see where I am going. The stock of a good company with a decent dividend yield suddenly doesn’t look so expensive, anymore.

So yes, keep investing in stocks. Just being a bit more selective would be prudent. Two examples.

1) When interest rates rise, it will be even more important for companies to have solid financing. Companies with high gearing suffer from increasing costs of financing.

2) Companies in countries with high debt may face higher taxes their governments need in order to finance the interest costs of that debt.

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