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
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.
What happens when interest rates start going up?
For example, from 2% to 5%.
- The most obvious impact is that our company starts paying higher interest on its debt. $5 instead of $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%!
- 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.
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.
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?