Demystifying the economy | Interest rate and market value

Every Saturday, one of our journalists answers, in the company of experts, one of your questions on the economy, finances, markets, etc.

Posted at 7:00 a.m.

Martin Vallieres

Martin Vallieres
The Press

My question stems from the context of anticipation of upcoming interest rate hikes by central banks in order to calm inflation in the economy. In the stock market, why do we say that higher interest rates can reduce the value of stocks?

Alain Wolff

In order to adequately answer this question, The Press called on Jean-René Ouellet, vice-president and investment strategist at Desjardins Wealth Management. He offers a two-pronged answer.

Lure competition

The first aspect stems from the situation of competition between the various investment securities offered on the financial markets to attract capital from investors.

“Professional investors closely monitor the equation between the level of market risk (rise or fall in value) and the expected return of their securities in their portfolio, explains Jean-René Ouellet.

“When bond yields are very low, if not close to zero, for an extended period of time, while equity markets offer a base dividend yield of around 3%, not to mention the potential for value gains, fixed income securities are less attractive than equities for attracting capital from investors with a minimum tolerance for risk. »


PHOTO PROVIDED BY DESJARDINS WEALTH MANAGEMENT

Jean-René Ouellet, Vice President and Investment Strategist, Desjardins Wealth Management

However, when interest rates are rising, this basic yield advantage of equities over bonds can quickly fade and even reverse as rates rise.

“In fact, as interest rate hikes materialize, and bond yield basis improves, a growing number of investors are motivated to reduce the equity allocation in their portfolios – considered as risky assets – in order to enhance the bond allocation based on their risk management in the portfolio, explains Mr. Ouellet.

“Consequently, it is in anticipation of such a phenomenon that signals of forthcoming interest rate hikes from central banks are often the cause of bearish episodes on the stock market. »

Impact on future results

The second part of Jean-René Ouelllette’s explanatory response stems from the impact of a rise in interest rates on the next results of listed companies.

“The fundamental value of shares on the stock market depends a lot on the expectations of future results and profits of the company or business entity that issued them,” recalls Mr. Ouellet.

However, for companies that are more indebted, or whose profits are very weak or non-existent, a rise in interest rates augurs higher financing costs to the detriment of their future results.

Moreover, a rise in interest rates may affect the purchasing and investment power of the customers of these companies, which could harm the growth of their income (sales) and profits.

From the point of view of stock market investors, this risk of impact on the next results of companies influences their perception of the value attributed to their shares.

Jean-René Ouellet, Vice President and Investment Strategist, Desjardins Wealth Management

“In the stock market, this is what is measured in particular by the “price-earnings multiple” (P/B) attributed to the shares of listed companies. And as we have seen since the start of the year, it is the stocks or market indices with the highest P/E multiples whose value is most affected by the signals of an upcoming rate hike, reports Mr. Ouellet.

“On the US stock market, for example, the NASDAQ market index, which is dominated by growth-type technology companies and whose P/E multiple recently quoted close to 30 times, has been much more affected since then. the beginning of the year (-15%) than the more general S&P 500 market index (-8%), which posted a P/E multiple in the low twenties. »

This comparison is also eloquent in the case of the S&P/TSX index of the Canadian Stock Exchange, where so-called “value” companies prevail in financial services, energy and raw materials. With its P/B multiple around 15 times, the S&P/TSX is down just 0.6% since the start of the year.


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