It’s hard to escape the constant chatter about rising interest rates lately, so it was only natural for a client to ask about the interplay between interest rates and asset prices.
Interest rates are an essential driver of asset prices. You don’t have to take it from me – here’s a quote from famed investor Warren Buffett on this topic:
Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices
Why exactly is this the case? Let’s focus on an equity security (ie: a share of stock) for this illustration (but know the same logic can be applied to virtually any economic asset)
When determining the price of an equity security, in the simplest terms, you are seeking to calculate the present value of the future cash flows of the business (that you will have a right to as an equity holder). Said another way, what should you be paying today for the stream of earnings this business will generate in the future?
In formulaic terms:
Numerator = business earnings in the future (ie: revenue of the underlying company less expenses less taxes)
Denominator = interest rates (ie: gravity)
Using basic division, the value of an equity will go up (all else constant) if the numerator rises or the denominator falls. This was the dynamic we had in mid to late 2020. Earnings were rising for many companies, driven largely by fiscal stimulus in response to COVID = numerator up. At the same time, monetary policy pushed interest rates to zero to spur borrowing and spending = denominator down. Numerator up. Denominator down. Stock prices up.
On the other side, the value of an equity will fall if the numerator declines and/or the denominator rises. Sound familiar? It likely does as it is what we’re facing in most of 2022. Earnings estimates are coming down, as the so called pandemic pop wanes = numerator down. At the same time, monetary policy is now focused on bringing rates up (in an effort to slow spending and tamp down inflation) = denominator up. Numerator down. Denominator up. Stock prices down.
Using this somewhat simplified calculation, you can see why interest rates are so important. The value of any business or equity or economic asset is 100% sensitive to interest rates. The higher rates are, the lower the present value is going to be (all else constant).
This interplay is largely why there is so much volatility in equity and bond markets in recent weeks and months. The market cannot determine when and where the Federal Reserve will stop rising rates (and when they can in fact pause or even start bringing them back down again). This uncertainty is leading to meaningful swings across the yield curve, which is resulting in similar moves to the denominator in valuation calculations.
There is no need to fight against “gravity” – once investors understand this undeniable interplay, it is far easier to establish your investing approach and weather changes in interest rates in stride.
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