The Yin and Yang of Finance: How Rising Interest Rates Affect the Stock Market

Authored article by Mohit Ralhan, Chief Executive Officer of TIW Capital

Stock Price Movement in Continuously Increasing Interest Rates 

Investing in stocks has been one of the most significant wealth creators and at the same time, it has the potential to be a wealth destructor, if not done correctly. Therefore, the search for those macroeconomic, behavioural and technical factors, which can enable an investor to predict stock price movements has been a long and unending quest. Several factors have been studied and even today it is an area of significant research. In the short term, stock price movements seem to be quite random and now investors are trying to make sense of that by leveraging the emergence of the latest technologies such as predictive data analytics, artificial intelligence and machine learning. But when it comes to long-term investing, there is only one factor that has an undeniable and extremely strong correlation with stock prices and that is expectations of earning growths of companies. Every other factor feed into changing investor’s expectations of earning growth and in that context, changes in interest rate is no different. 

In general, there is a negative correlation between the increase in interest rates and stock prices. If we compare Nifty return since 2001, there is a substantial difference in average daily returns between the periods when RBI was in a rate hike cycle and when it was not. The average daily return during rate hike cycles has been only 0.04 per cent while at other times it has been 0.21 per cent. This indicates that while an absolute price correction might not have taken place during monetary tightening in India, stocks have underperformed vs their long-term average. But this is not true for all such rate hike periods. 

Since 2001, the country has seen five cycles of increase in interest rates: 2005 to 2008, 2010 to 2011, 2013 to 2014, 2018 and 2022 onwards. In three of these, the benchmark Nifty 50 delivered a positive return. This seems counterintuitive, but it is not, since finally, it is all about earning growth. An increase in interest rates does impact earnings negatively because of two reasons. First, the cost of borrowing goes up and therefore companies with debt on their balance sheet face a potential earnings decline. Secondly, there is a multiplier impact since fewer earnings also mean lesser capital availability to fund future earnings growth. But what if the companies continue to grow their earnings despite an increase in interest rate? It may happen during periods of high growth where despite a rise in interest rates, demand and inflation continue to remain high, enabling most companies to pass on inflation to their customers. Since companies can not only sell more but can also sell at higher prices, they continue to demonstrate strong earnings leading to an increase in their stock prices. This is exactly what happened between 2005 and 2008 as Nifty 50 EPS grew by ~66 per cent from Rs 169 to Rs 281 and Nifty 50 delivered a return of ~78 per cent despite an increase in interest rate during this period. 

In the other four periods of rate hikes, Nifty has delivered subdued returns of -1.0 per cent, 0.2 per cent, 7.1 per cent and 0.7 per cent respectively, during the periods where growth expectations were getting moderate as well. For example, between 2010 and 2011, inflation was in double digits while growth fell from 8.5 per cent in 2010 to 5.2 per cent in 2011. Nifty EPS growth was subdued at a CAGR of 3.9 per cent over FY 2008-2011. 

So, the effect of rising interest rates on stock prices mainly depends on whether it is taking place in an environment where growth expectations also remain strong or not, i.e., whether the companies have the required tailwinds to withstand the negative impact of higher interest rates. The recent cycle of interest rate hikes has also happened in an environment where there has been significant uncertainty regarding growth expectations which reflects in the relative performance of Nifty in comparison to previous years. 

Export sectors and banking tend to do better during periods of increasing interest rates. Usually, there has been an overlap between Fed and RBI tightening, since RBI also needs to keep the interest rate differential between USA and India in a narrow range. But this still results in depreciation of the rupee which tends to support export sector earnings. Energy and metals also perform well as high-interest rates are usually seen during inflationary periods. Commodities tend to be a contributor to these inflationary pressures. In consumption, staples tend to outperform discretionary consumption. As a framework, investors should look at companies that have zero debt and higher pricing power giving them a better ability to pass on input inflation since higher interest rate periods are typically associated with periods of higher inflation.  

The periods of rate hikes require a reassessment of the portfolio to determine its impact on the portfolio earnings. It’s not necessarily a good or bad event but it changes market opportunities and investors need to be alert to not only respond to it but take advantage of it.