How do interest rates affect stockmarkets?

Ask yourself this – how much would someone have to give you in a year’s time for you to hand over $100 today?

Assuming it is guaranteed they will pay you back, is it $105? $107? $110?

The amount that would make you ambivalent about whether you had the cash today or received it in the future is known as the ‘time value’ of money.

The percentage difference between the two numbers, meanwhile, is known as the ‘discount rate’.

The discount rate vs interest rate

There is an extremely strong link between the discount rate and the interest rate and this is because, if you had $100 today, you could put it in a bank account and earn interest over the coming year.

The more you can earn in interest, therefore, the greater the amount you need to receive in the future to compensate you for not receiving that interest.

If, for example, interest rates were currently 10%, you would not accept less than $110 in a year’s time as, obviously enough, you would otherwise be better off taking your $100 as it is now and stashing it away in a bank account.

When interest rates are 0%, however – as they effectively are today – the future amount you would accept for your $100 now is likely to be lower. In this scenario, perhaps $102 would suffice.

We can also turn this question around

If we know we want to receive $110 in three years’ time, say, how much would we need to set aside now?

The answer to that question would again depend on where interest rates stood. If interest rates were high, you might only need to set aside $100. If they were low, however, the amount might be closer to $108.

Why interest rates move stock prices 

This, in effect, is the sum the stockmarket is trying to solve – and why interest rates move share prices.

While the value of a theoretical company in, say, 2030, may not move in itself, a reduction in discount rates triggered by a reduction in interest rates will have an effect.

If, then, that company was seen as worth $110 in 2030, with interest rates high, the share price today may be $100.

With interest rates low, the company may be worth $108.

Impact around the world

The reduction in interest rates that has been seen around the world has had precisely this impact on stockmarkets globally.

It should, in other words, come as no surprise that share prices have seen a succession of all-time highs in different countries – at a time of historically low interest rates, such moves are totally understandable and justified.

That said, investors need to remember the mantra intoned by central bankers around the world as they responded to the credit crunch by cutting rates to these levels was ‘lower for longer’ – not ‘lower for ever’.

What we think about rate rises

While the impact that will have on markets is impossible for anyone to predict with any certainty, we believe we can say two things with some confidence.

  1. A market that has become used to low rates is likely to have some adjustments to make.
  2. In the process of making those adjustments, the market is likely to overreact in some areas, creating opportunities for stockpicking investors.

We sincerely hope the adjustments to come do not prove too painful.

That said, our value-oriented investment process is specifically designed to take advantage of emotion and overreaction within the wider market and more than a century of history suggests that we and our investors should benefit from the sort of environment likely to prevail as and when interest rates start to rise. Past performance though is, as ever, not a guide to future performance. 

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This material has been issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders) for information purposes only. It is intended solely for professional investors and financial advisers and is not suitable for distribution to retail clients. The views and opinions contained herein are those of the authors as at the date of publication and are subject to change due to market and other conditions. Such views and opinions may not necessarily represent those expressed or reflected in other Schroders communications, strategies or funds. The information contained is general information only and does not take into account your objectives, financial situation or needs. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this material. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this material or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this material or any other person. This material is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any references to securities, sectors, regions and/or countries are for illustrative purposes only. You should note that past performance is not a reliable indicator of future performance. Schroders may record and monitor telephone calls for security, training and compliance purposes.

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