Fund Insight ODDO BHF AM Polaris

In 2023, the central banks' fight against inflation and market interest rates will continue to be the focus of interest for many investors. Key interest rates have risen globally and have not yet peaked, while at the same time the impact on the banking system is becoming more visible. Therefore, in this Fund Insight we would like to look at how much equity market valuations depend on the interest rate level.

LOW VS. HIGH MARKET INTEREST RATES

From a financial perspective, equities are the promise of future distributions, usually financed by the cash flows generated by the company. Since investors have safe alternatives, e.g. government bonds, at their disposal, the interest rates that can be earned on them (in addition to a risk premium) must be taken into account when valuing equities. Typically, these calculations aremade by analysts in a "discounted cash flow" model (DCF model). The interest rate is in the denominator, i.e. higher interest rates result in a lower share value - and vice versa. The exact mathematical effect of rising interest rates depends on the starting level, but one can roughly assume a 20 % lower share value if interest rates rise by 1 percentage point, for example from 2% to 3%.

FROM THEORY TO PRACTICE: INTEREST RATES AS A CRISIS BAROMETER.

So if we look at the interest rate effect on shares in isolation, rising interest rates should lead to falling stock markets and falling interest rates to rising share prices. So should shareholders always hope for lower interest rates and tremble at the spectre of rising ones? In practice, we not infrequently see the opposite. Time and again, falling market and central bank interest rates and falling stock markets have occurred together. For that is when the risk premium on interest rates mentioned above in the DCF model comes into play. Falling interest rates are often a sign of worsening economic prospects or harbingers of crises. This can affect companies' earnings prospects (in the numerator of the DCF model) and the risk premium on interest rates (in the denominator), to the chagrin of shareholders.

On the other hand, a higher interest rate level should also not necessarily serve as an argument against investing in shares. If higher interest rates are an expression of an improved economic environment and companies can compensate well for higher inflation, profits rise faster than in the low-interest phase, so the numerator in the DCF model rises faster. Another question: Were the ultra-low, partly negative interest rates that prevailed until 2021 ever fully priced into the stock market? If this was not the case, the effect of interest rate normalization is also not so negative for expected stock returns.

CONCLUSION:

For many market participants, the current question is whether the transition to higher interest rates is negative for equities, and one should therefore reduce them in portfolios. As shown, the answer is complex and the exact implications for the equity markets are ambivalent. A focus on another factor, which in the long run even dominates, seems at least as important: corporate earnings growth. Here the numerator is considered in the DCF model. Structurally and steadily growing quality companies benefit from this tailwind, which dominates the mathematical effect of interest rates in the denominator over the long term and should lead to above-average performance. With a focus on quality companies, one is therefore on the safe side in the long term even with a higher interest rate level.

Find the full Fund Insight in the document below :

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Gunther De Backer

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Olivier Duquaine

Managing Director, Backstage Communication

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