Why interest rates might be behind the stock market recovery

Given the pretty bleak economic data over the last couple of months the stock market’s behaviour is striking. A looming recession is rarely good news for company profits, and yet the S&P 500 index (which tracks the performance of the 500 largest listed companies in the US, the world’s largest stock market) is little moved from the start of the year.

In this article we look at the impact of interest rates on share prices, what this means for investors and what lessons investors need to remember.

This article isn’t personal advice. If you're not sure what’s right for your circumstances, please ask for advice. Unlike cash, all investments and their income fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.

Interest rates changes

One of the first steps taken by governments and central banks in response to the coronavirus outbreak was to cut interest rates. In the UK the Bank of England base rate fell from 0.75% at the start of March to 0.1% by the end.

Cutting interest rates makes borrowing money cheaper and aims to stimulate the economy by encouraging consumers to spend and companies to invest in new equipment and materials. It also makes cash saving less attractive, encouraging investment in riskier assets like stocks & shares. However, lower interest rates also have a more direct effect on share prices.

What interest rate changes mean for share prices

If you were to give me £100 I could put it in a bank account and earn interest. Assuming an interest rate of 1.2% I’d have £101.20 this time next year. In other words I should be indifferent between £100 today and £101.20 next year – financially speaking they’re equivalent.

A consequence of this is interest rates affect the value I put on money to be received in the future.

If interest rates were 5% I would need to put £100 in the bank to get £105 in a year’s time. In other words consider £105 next year equivalent to £100 now. However, if interest rates fell to 1% I’d need to put £103.96 in the bank in order to end up with £105. I should now value £105 next year at £103.96. A future payment has become more valuable today just because interest rates fell!

How does this all apply to shares?

Well, companies are valued based on the current value of all future profits – academically speaking, a company’s shares should be worth the same as the present value of future profits. And as we saw above, when interest rates are low money in the future is more valuable. Take the example below.

Scroll across to see the full table.

We’re looking at a company expected to generate £50m of profit each year for five years. We’ve ‘discounted’ the value of each year’s profit to work out its value today (or present value). For simplicity’s sake we’ve used the Bank of England base rate at the beginning and end of March to do this.

The example shows that, even if profit expectations remain unchanged, lower interest rates increase the present value of future profits. All things being equal we’d expect a lower interest rate to result in a higher share price.

However, you’ll notice that the change in interest rate has a greater impact on the present value of years in the distant future than on the present value of next year’s profits. That’s important because, unlike the example above, you’d hope a real life company can continue to deliver profits for decades to come.

When interest rates become more important than profits

In the below example we’re again assuming that the company generates £50m of profits next year. However, instead of limiting the scope to five years they’re going to stay at that level forever. How much would £50m a year in perpetuity be worth and what effect would changing the interest rate have?

Because we’re talking about a much longer period of time the change in interest rate has a much greater effect on the company’s overall value. In fact simply changing the interest rate changes the present value of all future profits from £6.7bn to £50bn.

The change in interest rate is so powerful that even if we assume a 20% fall in profits (from £50m to £40m) alongside the changing interest rate, the overall value of the company still rises from £6.7bn to £40bn.

Limits and lessons from the effect of interest rates

Now before getting carried away and assuming lower interest rates mean stocks and shares are destined to fly, there are some important things to consider.

Firstly the examples above are extremely simplified. In reality investors don’t simply use the Bank of England base rate to discount future company profits – that would be ignoring a whole range of risks. What if the company goes bankrupt or profits fall dramatically? Accounting for these risks dramatically lowers the “Present Value” of future profits and a much lower estimated share value.

Secondly the influence of interest rates also works in reverse. It’s been a long time since we saw a sustained increase in rates but we’re at an all-time low and it seems safe to assume that (eventually) rates will rise. When that happens you would expect share prices to fall.

Given those caveats why does the current interest rate environment matter? Well interest rates are one of the fundamental bedrocks of investment theory – they allow us to put a value on money we expect to receive in the future. We’ve never seen rates this low and that makes outcomes difficult to predict.

That unpredictability is a strong reason for investors to make sure they’re appropriately diversified – holding a mixture of both cash and shares within a well-diversified portfolio. Missing out on a strong performance in shares would be painful, but so would risking a reversal in prices.

---

---

Editor’s choice: our weekly email

Sign up to receive the week’s top investment stories from Hargreaves Lansdown