Many wealth managers realize the power that Federal Reserve actions or inactions have to move financial markets. The financial world seemingly stops when the chairperson, or even a regional governor, of the Federal Reserve speaks.

The most memorable case of the market reacting to the pronouncements of a Fed chairman was the famous - or, if you’re a stock market bull, infamous - “irrational exuberance” phrase uttered by Fed chairman Alan Greenspan. The immediate response was swift and dramatic. While the U.S. market was closed at the time, world markets started a free fall as investors became increasingly worried - more like panicked - that the Fed would soon raise interest rates to slow down the economy. (For related reading, see: Alan Greenspan: 19 Years in the Federal Reserve.)

Why Do Interest Rates Matter So Much to Investors?

In an interview in April of 2017, Berkshire Hathaway Chairman and CEO Warren Buffett said, “Everything in valuation gets back to interest rates.  The most important thing is future interest rates.” So why are interest rates so important?

Unlike the buyers of assets, such as homes and cars, the purchasers of financial assets are a notoriously unsentimental lot. Investors don’t get a lot of psychic income from the purchase of financial assets. They don’t brag to their neighbors about their stock position in Tesla or engage in conspicuous consumption of Berkshire Hathaway bonds. Investors simply want to acquire more future purchasing power in exchange for the current purchasing power they deny themselves. It’s really no more complicated than that.

The value of any financial asset - stock, bond, option contract, futures contract, real estate investment or gold - is equal to the present value of all future cash flows from that asset. The interest rate that you use to come up with a present value is referred to a discount rate. The Federal Reserve discount rate is a special type of discount rate that is set by the Fed on its loans to member institutions. A discount rate is appropriately named because the dollar amount to be received in the future is discounted (or made less) to arrive at its present value. In general terms, the value of any asset is calculated as:

Value = CF1(1+i)1+ CF2(1+i)2+…+CFN(1+i)N

In this equation, i is the discount rate. And as the interest rate increases, all else equal, the value of the asset decreases. For example, let’s look at the value of a cash flow of $50 a year for 20 years as interest rates rise. You can see that as interest rates along the x-axis increase, the present value of the stream of cash flows declines. (For more, see: How Much Influence Does the Fed Have?)

While the Federal Reserve doesn’t set market interest rates, it has an enormous impact on market interest rates through its three tools of monetary policy - open market operations, changes in the discount rate and changes in the computation of required reserves. The Fed signals its intention to market participants through its public statements and these statements are closely scrutinized by the market for clues about the path of future interest rates. The statements help market participants determine if the Fed is undertaking an expansive monetary policy - one in which interest rates trend downward due to an increase in the money supply - or a restrictive monetary policy - one in which rates trend upward due to a decrease in the money supply.

Effect of Interest Rates on Stocks

Changes in interest rates can also affect the cash flows from certain investments - specifically stocks.

Historically, the stock market has performed much better when the Federal Reserve was undertaking an expansive monetary policy rather than a restrictive one. In research first reported in Invest With The Fed (McGraw-Hill, 2015), and subsequently updated, from 1966 through 2016, the S&P 500 returned 15.2% annually when rates were trending down and only 5.8% when rates were trending up.

After factoring in inflation, the real (inflation-adjusted) return during restrictive monetary conditions is a paltry 1%, while during expansive conditions the real return on the S&P 500 is a robust 12.3%. The implication for wealth managers is that they should counsel clients to expect to earn lower stock market returns during restrictive monetary policy conditions.

The impact of interest rates on stocks make sense because business profits are affected by changes in interest rates in two ways. First, as interest rates rise, a company’s borrowing costs, or its cost of debt capital, also rises. Second, the demand for discretionary products often rises and falls with changes in interest rates. Let’s talk about each of these items in greater detail. (For more, see: How Interest Rates Affect the U.S. Markets.)

Interest Rates and Borrowing Costs

The profitability of businesses is influenced by changes in interest rates as a result of the fact that businesses often borrow money to fund a portion of asset purchases and the cost of ongoing operations. As interest rates rise, the cost of borrowing capital goes up. Additionally, as the cost of debt capital rises, the cost of equity capital also rises because stock investors require a risk premium above the risk-free rate - and the risk-free rate is now higher because of the rise in interest rates. All else equal, as interest rates rise, a firm’s cost of capital rises and its profitability falls. This can be seen by looking at a simplified income statement for a firm:

Revenues

Less: Cost of Goods Sold

Gross Profit

Less: Selling, general and administrative expenses

Earnings before interest and taxes

Less: Interest Expense

Earnings before taxes

Less: Taxes

= Net Income

Interest Rates and Demand for Discretionary Products

The aggregate amount of consumer spending is dramatically influenced by changes in interest rates. As interest rates rise, growth in consumer spending typically falls in the aggregate. For example, demand for new automobiles or new home construction will often decline as interest rates rise. Rising interest rates make the new product much more expensive since autos and homes are generally purchased with a combination of equity and borrowed funds, and consumers often shy away from incurring debt when the cost of debt rises.

Although rising interest rates and rising inflation affect all industries, industries selling big ticket items that require the consumer to incur significant debt are especially vulnerable to increases in interest rates. Companies selling lower-cost items, such as tobacco and food products, are less susceptible to changes in demand for their products that result from changes in market interest rates. People may choose not to build new homes or buy new cars when interest rates rise, but they still need to heat their homes, eat and brush their teeth.

Putting These Two Influences Together

Returns to the stocks of companies in different sectors vary dramatically in expansive versus restrictive Fed monetary policy periods. This happens as a result of changes in borrowing costs and patterns of consumer spending.

Sector Stock Performance: January 1966-December 2016 (Percentage returns are annualized)

The implication for wealth managers is that when interest rates are trending upward, they may want to lessen their clients’ exposures to durable goods manufacturers, such as construction and autos, and increase exposures to the energy, consumer goods and food sectors. And be aware that a rising interest rate environment may not be good news for stock returns. (For related reading, see: The Federal Reserve System Affects You More Than You Might Think.)

This article is adapted from a presentation contained in the Wealth Management Certified Professional (WMCP®) Program offered by The American College of Financial Services.

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