Column
Fundamental
Australia

The relationship between interest rates and equities

4 Aug 2020
By
One continuing point of confusion I get when I talk to members is the assumption that a strong economy naturally translates into a strong stock market and vice versa, and therefore the natural conclusion that the incredible rally from the March lows is simply a bubble forming in the market.

The lasting effects of the pandemic will obviously continue to play a huge role in the direction of markets in the near-term (and even longer if the hope of effective vaccines and therapeutics don’t eventuate or take longer to arrive), but this pandemic is effectively a one-off shock to economies and companies; admittedly a very large shock but assuming a vaccine does indeed arrive will be one-off in nature.

So, while the pandemic is likely to prove a one-off shock, a far bigger determinant of the value of equities is long-term interest rates. The very simple relationship between interest rates and equities is that low interest rates are good for equities and high interest rates are bad for equities, but why is this? A very common way to value an asset is to add up the total of all cash flows (future and current) and assign them a value at the present point in time. This is called a discounted cash flow model (DCF). Long-term interest rates, or discount rates in this model, are used as the opportunity cost of having your capital held up in the asset. Effectively what this means is that while $1.00 today is worth more than $1.00 in one year, that difference becomes less the lower the risk-free rate on offer.

Let’s extrapolate this concept to equities during this period of volatility. On January 1, 10-year US government bonds (effectively the expected risk-free rate in 10 years) was 1.92%. That 10-year rate is now 0.56%. In a vacuum, if there was no pandemic and the earnings outlook for equities was identical, then clearly the value of equities in this scenario would be significantly higher. Of course, there is a pandemic and there has been a huge impact on the future cash flows of all companies is why the market performance has been reserved for those companies less impacted by the pandemic. But while the pandemic will have a long-term impact on global economies that have borrowed money to provide support to their citizens and this will keep a lid on interest rates for a long time, if you can accurately predict the future cash flows of listed companies then there is a lot of money to be made.

Of course, not all companies have been negatively affected and there is no exaggerating how many members I’ve spoken to just naturally assume the rally in tech stocks is a disaster waiting to happen. And frankly, it is not just market beginners but also seasoned value investors – even Warren Buffett would be lumped into this category – that continue to get the tech sector wrong. The tech sector, unlike the majority of industries, have actually seen the pandemic accelerate the tailwinds supporting the growth of these companies and when you combine increased expected future cash flows with far lower interest rates, the increase to present-day valuations is significant.

So, I think it is important for investors to stop linking expected performance of stocks to where they were trading at before the pandemic shocked the world. The investing outlook is so different in only six months and the long-term outlook for interest rates is a tailwind for equities that can’t be ignored.

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