INFLATION AND INTEREST RATES

The past two years have been dominated by discussions about interest rates and inflation. Since most people are not economists, I thought I would try to shed a little light on why these topics are so important for your investments.

Inflation's Impact on Interest Rates

When inflation spikes like it did in 2022, interest rates would typically increase so that lenders can get a rate of return on their money that exceeds inflation. In addition, the Federal Reserve raises interest rates to attempt to slow down economic activity. The Fed is hoping that the slowdown in economic activity (demand) will stop prices from rising. Their strategy seems to be working so far in 2023 as the rate of inflation has declined significantly.

But the Federal Reserve has stated that they will not begin to decrease interest rates until the rate of inflation drops to their target rate of 2%. Currently, inflation is around 4%. The Fed has indicated that they will be maintaining their high interest rates until the end of next year.

As a result, investors are not expecting interest rates to change much over the next 12 months or until the Fed starts lowering rates.

Interest Rates and the Stock Market

Interest rates have a pretty significant impact on the stock market. Changes in interest rates often lead to changes in stock prices particularly when interest rates increase.

Let’s look at why that happens.

One reason for this is the competition among investment assets. With only so many investment dollars to go around, money invested in bonds (interest bearing assets) represents money that is not invested in stocks. When interest rates on bonds increase, they become more attractive investments than stocks. When funds move from the stock market to the bond market, stock prices tend to decrease. This is exactly what happened in 2022.

The same thing happens in reverse. If interest rates on bonds are very low, investors are drawn to the potential for higher returns in stocks. Many people think that the rapid rise in stock prices between 2010 and 2021 was partially driven by the extremely low interest rates during that time. In the previous decade, interest rates were often close to zero. Investors were almost forced into owning stocks as bonds became much less attractive.

In the 1970s, inflation and interest rates were at extremely high levels. Bonds were earning as much as 15% per year and people were taking on mortgages with interest rates in the mid-teens. Money moved out of the stock market and into the bond market in the 1970s. As a result, the stock market dropped significantly in the mid 1970s.

There is another important reason why interest rates affect stock prices. Unfortunately, it is a little complex to describe. Investors value stocks based on the projected cash flows of the businesses they represent. Future cash flows are discounted based on current long term interest rates. When interest rates are higher, the future cash flows are discounted more. Therefore, when interest rates rise, the financial value of every company’s cash flow decreases. Stock prices decline as a result.

Since technology and high growth companies have higher projected future cash flows, their stocks decrease more than other companies when interest rates increase. This is why the Nasdaq and technology stocks lost more value in 2022 compared to the S&P 500. The Nasdaq dropped 30% in 2022 while the S&P 500 dropped by 20%.

Both the S&P and the Nasdaq have rebounded nicely in 2023 even though interest rates have not decreased this year. Investors are anticipating that interest rates will be decreasing, however, and that has led to the increase in stock prices this year. Inflation has decreased significantly and that has created the expectation that interest rates will drop in the future.

CONCLUSION

The main thing you need to know from all of this is that rising interest rates are bad for stock prices and declining interest rates are generally positive for stock prices. You also need to be aware that higher growth technology stocks are more affected than slower growing stocks. The financial and economic news can be confusing, but it really is that simple as far as interest rates and stock prices are concerned.

Happy Investing,

Phil

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