The Triple Action of Interest Rates

As the saying goes: Don’t Fight the Fed.

Here is my rather naive understanding of how Interest Rates influence equity markets and why I’m still bearish.

Let’s have a look at a very simplistic example of the following company:

Share price: $100
EBIDTA: $10/year
Debt: $100 (variable interest rate: 2% = $2/year)
Dividends: 3% = $3/year (payout rate is only 37.5%, nice!)
To keep things simple, the company pays no taxes.
—
Bottom line: after all the payments, we end up with $5 extra dollars every year.
$10 – $2 – $3 = $5.
Pretty amazing.

What happens when interest rates start going up?
For example, from 2% to 5%.

  1. The most obvious impact is that our company starts paying higher interest on its debt. $5 instead of $2.
  2. The less obvious impact is that clients of the company also start paying more interest and thus have less money to buy the products of the company.
    Countering this with the price increase, let’s say EBIDTA drops from $10 to $9 per year.
    After paying $5 in interest and $3 in dividends, the company ends up with just $1 extra.
    Dividends are already in danger. The payout rate jumped to 75%!
  3. This situation starts worrying shareholders. With rising interest rates, they have a choice between 3% dividends or 5% risk-free government bonds. Let’s say some shareholders are ready to hold/buy the shares only if it pays 1% on top of the risk-free rate, i.e. 6%.
    So, the stock price should fall 50% for them to consider buying or holding it.

There are probably other forces at play, but these are, in my opinion, the three most important.

And so that pushes stock prices down.
If interest rates stay high for too long, it might force some companies to start cutting their dividends to pay growing interest costs.
If dividends have already been cut to zero but shrinking earnings can’t cover interest payments anymore, the company might be forced to file for bankruptcy.

Ok, what’s happening now?
Interest rates are quite high already, but inflation is still not within the target range.
At the same time, with all the demand destruction, the price of oil (WTI) is around $80 a barrel again!
If it holds there long enough or goes higher, it will start pushing all other prices up.
Again.
From gas prices at the pump and up the chain: higher transportation costs, higher prices of goods, higher salaries, and higher service prices.

And then we have accelerating inflation.
Again!
That will force Central Banks to raise interest rates even more, or at least to keep them higher for longer.
That will push (and is already pushing) lots of companies to the brink.
At the same time, at least two Canadian banks (Tangerine and Simplii) are already offering risk-free 6% promo rates on Savings accounts.
There is also a 6% GIC from the same Tangerine, no need for a promo. 🙂
Every time I look at a stock, I ask myself: why should I buy it and risk my money when I can just get 6%+ risk-free?

7 comments on “The Triple Action of Interest Rates”

  1. This is somewhat funny:

    BMO Capital Markets on Wednesday said costs for oil and gas producers support current oil prices and justify higher natural-gas prices.

    “Supply costs bottomed in 2020 at roughly $60/bbl; since then, supply costs have marched substantially higher, rising 23% in 2022 due to inflation and some erosion in underlying productivity. We expect supply costs to continue to moving higher due to higher cost of capital, rising fiscal takes, and overall inflation. In addition, pressure to decarbonize and a focus on harvesting cash flow suggests commodity prices may need to move higher to promote investment. Meanwhile, it is evident in declining U.S. drilling productivity and global exploration success that producers must venture further out on the risk curve. We believe persistent cost pressure and chronic underinvestment since 2015 set the stage for higher oil prices and that the projected trend in cost structure underpins long-term support for oil prices >$80/bbl and gas prices ~$4/mcf,” the investment bank noted.

    Source: Supply Costs for Oil Producers Support Oil at US$80 per Barrel, BMO Capital Markets Says

    Higher oil prices is one of the drivers of inflation.
    But now inflation is driving oil pirces higher. 😀

    My believe is that interest rates should be higher for longer to break this inflation circle.

    Reply

  2. Everyone likes to predict something, so I’m going to make a prediction, because why not? 🙂

    There are three more Bank of Canada interest rate announcements this year: on September 6, October 25, and December 6.
    And at least one of them will very possibly have a 0.25% rate hike because the price of oil (WTI) is around $85/bbl now and the price of natural gas is slowly going up the closer we are to the winter months.
    These two start pushing inflation rates up again.

    Of course, it heavily depends on the thoughts and emotions of the people in charge, but the BoC’s main responsibility at the moment is 2% inflation and not GDP or unemployment rate.

    Also, an interesting post about inflation:
    Inflation in the Twenty-First Century: Unintended Consequences

    Reply

  3. A spike in gas prices pushed up U.S. inflation in August, yet most other costs rose at a more modest pace, evidence that consumer price increases overall are still cooling.

    Source: U.S. CPI rose 3.7% in August

    The “cooling” part is a total BS; it will reaccelerate if oil prices stay high for long enough.
    And WTI is trading around $89 already.

    Reply

  4. The Acceleration of Inflation in the Second Half Has Begun, “Disinflation” Honeymoon Terminated
    As far as I know, Wolf Richter is the only one who is talking about “health insurance CPI” distortion.
    And he also shares the same thoughts that higher oil prices will push inflation up.

    News is about USA, but it will affect Canada in the similar way.

    On the other hand, which totally makes no sense to me but is interesting to see the way of “thinking”:

    “The Fed has guided to focus on core (inflation), and the change in prices that we’ve seen is coming from energy,” said Michael Green, chief strategist at Simplify Asset Management, Philadelphia. “That suggests that the Fed is done raising rates and that’s removing concerns around equities.”

    “This is consistent with the idea of a soft landing,” Green added.

    Source: Wall Street rallies, oil jumps as data strengthens Fed pause bets

    Reply

  5. Well, Bank of Canada made a bad decision to not raise interest rates on September 6.
    Not their first bad decision, though.

    Statistics Canada says the country’s annual inflation rate rose to four per cent last month, up from 3.3 per cent in July.
    The rise in inflation was largely driven by gasoline prices, which were up on an annual and monthly basis.

    Source: Canada’s inflation rate reaches 4% in August

    The federal agency says although price growth accelerated on an annual basis, prices rose more slowly month-over-month as prices for travel tours and air transportation fell.
    Meanwhile, grocery prices rose at a slower annual pace, rising 6.9 per cent from a year ago compared with a reading of 8.5 per cent last month.

    My understanding is that transportation and grocery price growth lag oil price growth, so they will reaccelerate again.
    And WTI is around $92 now.

    Reply

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