Share prices follow the economy, not just the interest rate

What is the relationship between share valuations and interest rates?

Share prices (and share valuations) should eventually follow expectations about the state of the economy, not just the interest rate level. Company earnings are sensitive to interest rates, and theoretical share valuations are impacted by interest rate changes too, however it is the state of the economy that ultimately determines share prices.

Interest rates affect the level of economic activity, which increases when interest rates are low and decreases as interest rates rise. Higher levels of economic activity increase the demand for a company’s goods and services, boosting sales and earnings. As economic activity declines. demand for goods and services decreases, generally resulting in lower company earnings as a result.

This implies that the relationship between share prices and interest rates is an indirect one, and the overarching determinant of share prices in the long run is the state of the economy. This indirect relationship between interest rates and share valuations is explained by theoretical business valuations being calculated by discounting future cash flows to the present based on the cost of funds or required rate of return. A higher required rate of return will result in a lower valuation when rates increase because the expected return is a function of the discount rate applied to future expected earnings. The lower the discount rate (reflecting the perceived lower risk) the higher the current theoretical valuation, but the lower the future expected return.

This is why lower interest rates explain higher equity valuations, but they don’t always justify them. Justifying equity valuations with a low interest rate is a high-risk investment strategy, especially when interest rates are at all-time lows, which was the case in 2020. This notion was captured by the words of Warren Buffett when he said, ‘Price is what you pay, value is what you receive’.

Just as lower interest rates lead to higher capital formation simply because the internal hurdle rate for evaluating investments becomes lower, more investment opportunities are assessed as being more attractive. However, problems arise when interest rates (and the cost of capital) increase, resulting in lower theoretical asset valuations. This is why some investors exposed to downside valuation risk adopt the strategy to hedge their interest rate risk when they can, and not when they must.

Where are we in the current interest rate cycle?

Interest rates in Australia are set by the Reserve Bank (RBA) when determining the Official Cash Rate which is currently sitting at 4.35 percent. The RBA generally doesn’t provide detailed forward interest rate guidance but does outline how monetary policy settings will be adjusted in response to evolving economic conditions. Guidance is generally by way of a qualitative narrative and focuses on the Board’s policy objectives of inflation and unemployment. RBA Board members at the February 2024 meeting agreed that while inflation had moderated, it remains high and that it was too early to propose future rate cuts at the present time.

However, market consensus is that there is scope for the Official Cash Rate to be reduced later in the 2024 calendar year, perhaps in the December quarter. The current 90-day Bank Bill Swap rate is 4.35 percent which coincidentally is in line with the RBA Official Cash Rate at 4.35 percent. This tells investors that the Australian bond market does not anticipate a drop in the RBA Official Cash Rate until after June 2024.

Which industries and business sectors benefit from lower interest rates?

The sectors that benefit from falling interest rates are consumer discretionary, real estate, utilities, consumer staples and the materials sector. The banking sector benefits from lower interest rates, although history shows that banks benefit from interest rate volatility; in other words, whether interest rates are low or high, or are moving from higher to lower or vice versa, banks perform well under most economic circumstances.

While interest rates are an important investment consideration in the context of the overall share market, history shows that equity markets correct on the end of the business cycle, and not on a few interest rate hikes. Provided the business cycle remains reasonably buoyant and current interest rate settings don’t bring on an economic recession, or in other words result in a ‘soft landing’, equity markets should perform reasonably well in the period ahead.