How Interest Rates Affect Equity
The only reason most people pay attention to interest rates is because of their personal loans and savings. For these people interest rates represent a premium for either borrowing or saving money.
But if we look at interest rates on a macro level, their effect is much more wide spread. One of the main applications of interest rates is inflation control. The RBA (Reserve Bank of Australia) adjusts the cash rate to manage interest rates.
I like to think of the cash rate as the base interest rate. Banks use the cash rate to lend and borrow between each other. But when it comes to the public, banks will add additional percentage points to the cash rate. Why? Only one answer, to make a profit on their lending applications.
We’ve now determined that interest rates affect personal loans and the price you pay for goods, which are important to everyone. But if you’re an investor, interest rates have an even wider impact than the two above.
How interest rates affect Companies (in general)
As I said before interest rates determine the amount you need to repay on loans. This is also the same for companies. Public companies borrow large amounts of cash as sometimes their immediate funds aren’t enough.
Companies might need cash for the daily operations of the business or for acquiring another company. Higher interest rates of course mean a higher cost to borrow — so when interest rates are high borrowing tends to fall.
Interest rates not only affect companies’ borrowing propensity, they can also determine if the company will invest or not. For example if interest rates are too high then there are less business investments. If the interest rate is higher than other investment returns then it’s better for the company to park their money in the bank.
This is why the RBA may increase interest rates; to reduce spending. This reduction in spending will in turn slow down inflation. If you are a value investor these factors matter. Where the company allocates their capital, how much debt they have and what their earnings potential is in the future. These are just some of the information value invests want to find out.
The actual valuation of a company can also be affected by interest rates. Many investors like to predict a company’s cash flows and earnings for the future. But to discount future cash flows into today’s dollars, interest rates are involved.
The US aren’t turning back now
Let’ move to the US now and use what assumptions we know now about interest rates. The Federal Reserve said they were unlikely to reverse its plan to raise interest rates. In December last year the Fed decided to increase rates for the first time in years. And now Janet Yellen, head of the Fed, is reaffirming their strategy to hike rates.
If we look at this from a macro prospective then we could assume the Fed is trying to reduce inflation. Or the Fed wants to reduce borrowing. If this was their intention, who does it affect? Broadly, an interest in interest rates would affect everyone. Because it would cost more for everyone, companies and the public, to borrow.
You may be wondering why the Fed wants to lift rates at all. Global markets have had doom and gloom as their mantra for most of 2016. Analysts world-wide disagree with the Fed’s actions. And that’s probably why the Fed is proceeding cautiously.
‘I don’t expect the (Federal Open Market Committee) is going to be soon in the situation where it is necessary to cut rates,’ Yellen said. ‘There is always a risk of a recession…and global financial developments could produce a slowing in the economy,’ she added.
Of course Yellen and the Fed will act as the situation evolves but she doesn’t think it’s going to be necessary to cut rates. So if rates do rise, and the RBA follows suit, it could be more pain for debt ridden companies. One such sector that is debt ridden is Oil.
Companies like Santos Limited [ASX:STO] and Woodside Petroleum [ASX:WPL] are heavily in debt. A lot of these borrows are attempts to battle declining oil prices. Yet the debt has accumulated to level which might severely decrease their balance sheet health.
The same goes for mining companies. BHP Billiton [ASX:BHP] is our biggest miner, yet recently their credit rating was downgrade to A from A+. The reason for which was declining profits in the midsts of mounting debt. And if interest rates are expected to increase, it could get even harder for BHP to repay.
Evaluating specific companies is essential if investors want to invest within single stocks. However it’s also helpful to think of factors which affect businesses on a macro scale. Interest rates are one such factor that can affect a company’s balance sheet, investment opportunities and stock price valuations.
Junior Analyst, Money Morning
PS: The economy has been faring well this year. Analysts are predicting stock markets to pick up, but who know how long that will take. Let’s face it we’re in a bear market. And a bear market offers opportunities. The overall pessimism within the Australian market has made many stocks dirt cheap.
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