Unless you have been living under a rock, you would probably have noticed that interest rates have increased sharply over the last two years.
Investors may be wondering about the impact of such increases on share prices.
How will stocks react and will these increases be positive or negative for the businesses and the stock market?
Let’s dive deeper into how interest rates affect businesses and try to determine if there are any good investment opportunities resulting from these rate hikes.
The fastest rate hikes in history
The surge in interest rates has caught many investors by surprise.
Rates have risen faster than at any other time in history as the US Federal Reserve aggressively hiked interest rates to combat the highest inflation rate in the US in 40 years.
From 2022 to 2023, the Federal Funds rate was increased by 4.88 percentage points to the current range of between 5.25% and 5.5%.
The effective Federal Funds rate hovers at around 5.33% at last writing, and this rate is at a 22-year high.
The scourge of higher rates
Higher interest rates are generally bad for businesses because of their effects on borrowing costs and consumer sentiment.
Heavily-indebted businesses or those that rely on a steady flow of financing for their operations will be immediately hit by higher expenses as interest rates head higher.
As borrowing becomes more expensive, some businesses may hold back on their expansion plans by reining in capital expenditure.
This pullback has implications for the economy as it means that businesses are more hesitant to build capacity and grow their business.
Companies that take on debt for acquisitions (e.g. leveraged buy-outs) may also take a step back and re-evaluate their targets as the cost of such financing increases significantly.
Higher interest rates also flow to consumers, negatively impacting their purchasing power.
People with mortgages have to fork out more money as higher interest rates mean they need to pay more to reduce their principal.
Those with unsecured loans or other loans (e.g. renovation) will also have to pay more when rates rise.
These higher payments will crimp consumer spending and put a dampener on consumer sentiment, making them pull back on purchases of discretionary goods such as luxury items.
The overall effect on corporations and consumers is to reduce demand for goods and services, which may result in an economic slowdown as people and businesses tighten their purse strings.
As interest rates rise, people will park more money in savings accounts as deposit rates become more attractive.
The result is that money may get yanked from the stock market as more become satisfied with the higher deposit rates that banks are paying.
Investors who do invest in the market also demand a higher dividend yield to compensate them for the risk of investing their money.
This expectation will cause share prices to decline, all things being equal, to enable the stock to provide a higher dividend yield.
Sectors sensitive to interest rates
Several sectors are more sensitive to interest rates than others.
These include REITs, banks, property and property-related companies, and consumer discretionary.
The REIT sector is heavily reliant on debt for its operations and for acquisitions and asset enhancement initiatives (AEIs).
Several REITs have reported a year-on-year jump in finance costs as higher interest rates bite.
For instance, OUE REIT (SGX: TS0U) saw finance costs climb 18.5% year on year while net property income inched up just 1.6% year on year for the first half of 2024 (1H 2024).
On the other hand, the banking sector thrives on higher interest rates as it can lend out money at better rates to earn higher interest income.
Both DBS Group (SGX: D05) and OCBC Ltd (SGX: O39) reported strong earnings for 1H 2024.
DBS saw its 1H 2024 net profit rise 9% year on year to a record S$5.8 billion while OCBC’s net profit also increased by 9% year on year to a record S$3.9 billion.
The property development sector is negatively impacted by higher rates as such companies tend to rely heavily on debt to finance their projects.
Higher mortgage rates help to reduce speculation, causing property transaction volumes to tumble and negatively impacting real estate brokerages such as PropNex (SGX: OYY).
PropNex’s 1H 2024 earnings saw revenue dip by 5.1% year on year to S$345.6 million while net profit fell by 13.8% year on year to S$19 million.
Finally, as more people pull back on spending on wants, luxury goods companies will see a fall in sales because of lower demand.
The Hour Glass (SGX: AGS) saw its net profit for fiscal 2024 fall by 10% year on year to S$157.6 million as demand for luxury watches normalised.
Get Smart: An impending rate cut
We have established that higher interest rates tend to dampen consumer demand and slow down the economy as more companies hold back from spending and taking on debt.
However, there could be some respite as the US Federal Reserve could be on the verge of cutting interest rates to stimulate the US economy.
Investors should remember that interest rates are just one aspect to look at when they select investments for their portfolios.
Other attributes to look for are a business’s track record, its market position, and whether its management team can navigate different economic scenarios.
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Disclosure: Royston Yang owns shares of DBS Group.
