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The impact of rates
Why do interest rates affect stocks?

The financial press watches Alan Greenspan like a hawk. They always read between the lines of his comments - nearly obsessed with what he is "really trying to say". Why? Mr. Greenspan heads the U.S. Federal Reserve, which can be described as the banker of the U.S. government (i.e. the U.S. central bank). Its policy decisions regarding interest rates have an immediate impact on the markets. Canada's central bank, the Bank of Canada, recently raised interest rates. Why all of this attention on interest rates? Because rate changes have a very real impact on the value of stocks.

Monetary policy

Governments generally have two types of policies in their arsenal of economic management tools - fiscal and monetary. The bottom line is that all policies are designed, in one way or another, to influence how much money consumers spend. Fiscal policies deal with decisions on where the government spends money (and how much). As the government spends more money, generally more jobs are created. As more jobs are created, more people have more money, resulting in increased spending by consumers overall.

Monetary policy deals primarily with interest rates. This impact is most apparent in the housing market. Buying a house during the times of double-digit mortgage rates was much more costly than buying during today's ultra low interest rate. A $200k mortgage at 6 per cent amortized over 25 years would require monthly payments of about $1,280. If the interest rate goes to 9 per cent, the payment rises to $1,656 - an increase of nearly $400 monthly. Higher interest rates will result in lower spending on items that are normally purchased with borrowed money (i.e. house, car, etc.).

This week, the Bank of Canada raised the bank rate - the rate charged on overnight loans to chartered banks. (Banks sometimes borrow money for a day or two at a time from the Bank of Canada.) In the U.S., rates haven't yet changed.

Impact on stock prices

While the impact on consumer goods is more transparent, the impact on stock prices may not be. Interest rates affect stock prices in two fundamental ways.

From a company's perspective, higher interest rates translate into higher borrowing costs, which directly reduce a firm's bottom line. This effect varies by company, but this is the general rule. (For instance, companies with high debt levels will be more heavily impacted than firms with little or no debt.) Further, higher costs may also cause some projects to be postponed or cancelled. This has a two-pronged result. First, a cancelled project that was part of a company's growth strategy will now reduce the company's growth potential. Second, if many companies cancel or postpone projects, there is a very real impact on jobs and the amount of money people have to spend.

The less obvious impact of rising rates on stock prices has to do with a concept known as the Time Value of Money (TVM). Another way to think of it is the law of monetary gravity, except that this force isn't constant in direction or magnitude - it varies with interest rate changes. This "law" is demonstrated in the following example.

Given a choice between $10,000 today and $10,000 in 2012, which would you choose?

Of course, you would choose to receive the money today. Even if you could only invest it at today's paltry 2% money market interest rates for the next ten years, you'd still have $12,190 by 2012. (Let's ignore taxes for simplicity.)

Looking at it another way, $10,000 in 2012 is worth no more than about $8,200 today; because you could take that $8,200 today, invest it at 2% per year and end up with $10,000 in ten years. If you could expect to take a lump sum today, and invest it at an average of 4% per year over the next ten years, that $10,000 in 2012 would be worth $6,756 today.

The thing to notice here is that the higher your expected future interest rate, the less that future sum is worth today. The same holds with a stock's value, which can be summarized as the current value of the net profits or cash flow it generates in the future.

Generally speaking, higher future interest rates can both reduce future profits, but also reduce the value of those profits in today's dollars. However, I am of the opinion that markets tend to overreact to minute interest rate changes. A rate increase of 0.25 percentage points (as we saw this week) really has no meaningful impact on most companies. However, the market reaction may simply reflect the market's interpretation of the rate increase (i.e. that there may be much more to come.)

To read a more detailed investigation of the factors affecting stock prices longer term, take a look at my two articles in the February and March issues of Canadian MoneySaver magazine.

Looking ahead

In my second column of 2002, I warned of the likelihood of rising interest rates this year. While rates don't appear to be shooting near double-digit territory anytime soon, they do appear to be in an upward trend. Areas that tend to suffer most when rates rise include interest sensitive stocks (i.e. financial services, utilities, pipelines, and other higher yield stocks), government bonds, and other high yield securities like the hugely popular income trusts (particularly those based on the interest sensitive sectors noted just above).

I continue to expect rates to creep upward. Hence, holding a diversified basket of stocks (with a value emphasis of course) while continuing to weight cash more heavily than usual (at the expense of government bonds) remains a prudent strategy. Don't go overboard with portfolio adjustments, but some subtle fine-tuning could add some value.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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