Interest & Investment:

The relationship

Interest and investment have an inverse relationship. Stock markets are not directly affected by interest rates, but they do not remain unaffected either.  Stocks are valued taking into account the future cash flows of the company discounted back to the present.  If the future cash flow in the company is going to be poor due to higher interest rates, the value of the stock is bound to be affected!

How does the future cash flow of the company reduce? 

Companies get some of their funds from financial institutions in form of loans. When the interest on the funds from banks increases, they reduce the amount of capital they borrow from these financial institutions.  Consequently they cut down on their growth plans or their spending or investments.

Funds also are generated by sales of goods or services by the companies. When clients who avail of the services of the company or purchase the goods of the company, are squeezed for funds by high interest rates, they cut down on their spending and consequently the revenues of the company is reduced. The company then shows lower profits. This in turn, will result in the stocks being valued lower and the stock market index moving down.  Investments in shares of these companies will also show a dip.

When several companies are hit by the interest rate hikes, all stocks tend to get valued lower and the stock market index moves down. Investments too reach a low.

In such circumstances, investor expectations on stock price appreciation will be pessimistic.  Fewer investors will find the ownership of stock desirable.  Investment will shift to Government securities, treasury bills and bonds.  In other words risk free investments will appear more attractive.

How does increase in interest rates affect investors?

A large number of investors in the stock market also borrow funds from banks for investment purposes.  When the interest on such funds go up, the investors will cut down on their borrowing and on their investments. This again will affect market sentiment and will push the indexes down.  There will be fewer players in the market.

However, it is important to remember that interest rates are not the only factor that determines the investment behavior in the stock market.  It is just one of the factors. Smart investors will keep their fingers on the pulse and estimate stock sensitivity to changes in nominal and real interest rates and expected inflation.   They will also estimate the degree of indexation of future growth expectations to changes in interest rates and will also watch out for Governmental regulations, cyclicality of future cash flows and growth versus value characteristics of stocks and interest rate sensitivity across stocks. Such investors will continue to make investments.

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