Most people watch the latest decision on interest rates by the South African Reserve Bank (SARB) intently, because any change impacts our spending power and affects the economy and financial markets.
While most people are interested in the impact that interest rates have on debt repayments, DIY investors should also pay special attention to changes in movements up or down, as they have a profound impact on the prices of stocks listed on the Johannesburg Stock Exchange (JSE).
Setting rates
The SARB determines interest rates through its Monetary Policy Committee (MPC), which meets six times a year to assess the economy and decide whether to raise, lower, or maintain the repo rate — the benchmark interest rate at which it lends to commercial banks.
There are several interconnected economic and financial factors that influence this decision, with the MPC considering elements such as inflation, local and global economic conditions, GDP growth expectations, and developments in financial markets.
The decision typically triggers specific patterns in stocks listed on the JSE based on the direction interest rates move.
When Interest Rates Rise
Rising interest rates don’t only mean higher debt repayments for consumers on loans and outstanding credit balances. JSE-listed companies that rely on debt to finance operations, expansion, and investments also pay more when the SARB deems it necessary to hike rates.
The higher repayments on interest directly reduce profitability and net income, which can translate to lower earnings per share (EPS) and, consequently, lower stock prices.
Listed companies with the highest debt levels typically experience more significant falls in the stock price, especially when the Reserve Bank increases rates by a large percentage.
Markets also frequently determine stock valuations using a model known as discounted cash flow (DCF), which estimates the present value of a company’s future earnings or cash flows.
Interest rates serve as a key component of the “discount rate” used in these models. When interest rates rise, the discount rate increases, making future cash flows less valuable in present terms.
This mathematical effect leads to lower intrinsic stock valuations, pushing prices down. This impact is particularly pronounced for growth stocks, which derive more of their value from expected future earnings further down the line.
Higher interest rates also make other investments more attractive, as fixed-income investments, such as government and corporate bonds, money market and savings accounts may offer more attractive yields, often with less risk.
When safer alternatives offer higher returns, investors may shift capital from the stock market into these fixed-income assets, which creates selling pressure on stocks that drives down prices.
Another important factor to consider when interest rates rise is the impact this has on consumer spending. Increased borrowing costs on home loans, credit cards, and vehicle loans reduce disposable household income. The resultant decline in consumer spending can dent revenues and profits, particularly among consumer discretionary stocks, which will negatively impact stock prices.
The longer the economy spends in a high interest rate environment, the more pronounced these effects become.
Sustained high interest rates can eventually lead to a significant slowdown in economic activity, or even a recession, as borrowing and spending remain suppressed, which can put immense pressure on stock valuations.
When Interest Rates Fall
Conversely, when interest rates fall, borrowing becomes cheaper for businesses and consumers.
This reduces interest repayments, boosting profitability for companies and increasing consumer spending on goods and services.
Cheaper borrowing costs and bigger cash piles mean companies are more likely to invest in growth initiatives, acquisitions, and research and development, which increases their value. Improved earnings prospects also lead to higher stock prices.
Furthermore, a decrease in interest rates leads to a lower discount rate in valuation models. This increases the present value of future cash flows, making stocks appear more valuable, potentially pushing up their prices. Growth stocks, with their long-term earnings potential, often benefit most in this environment.
This upside potential from stocks typically sees a shift in asset allocations, with investors moving out of lower-risk assets, like fixed-income investments, savings, and cash, in the search for yield. The increased demand for equities also helps drive up stock prices.
A word of caution, though.
A prolonged low interest rate environment can lead to stock market bubbles and excessive risk-taking in financial markets, with investors more confident in taking on more leverage or risk in pursuit of higher returns. If there is a correction, stocks on the JSE can lose significant value in a short timeframe.
