Equities struggle when interest rate rises
Two school friends and veteran investors bumped into each other after decades in a coffee shop. As they sipped their cup, their ears perked up to a song ‘this is ourselves under pressure. Under Pressure.’
Veena: My portfolio has been under pressure recently. I was heavily invested in Nasdaq 100 funds, early stage technology and growth stocks and I thought they will continue to do well.
Ram: Some of them may do well in the long run, but in the short to medium term they will continue to remain under pressure if recently emerging concerns on inflation in the US persist.
Veena: Why should inflation or interest rates impact technology stocks.
Ram: Stock markets look to future earnings and discount it to net present value (NPV). When treasury yields move up on inflation concerns, your discounting rate increases and your NPV of earnings reduce.
Veena: Yes, but I still don’t understand why growth stocks should fall more than other stocks?
Ram: That is because the earnings of growth stocks are more back-end loaded. For example if you take a five-year period, most of the growth stock’s earnings may come only in the 4th and 5th year.Well-established companies which are likely to report consistent earnings..
Since the earnings are five years away, you need to discount it five times. When interest rates are low, it hence works in favour of growth stocks.
Veena: So, you mean when interest rates rise, the discounting rate increases and it impacts NPV of later year earnings?
Ram: Yes. Check this on excel. Assume discounting rate of 6 per cent and there are 2 companies A and B (growth) with same total earnings of Rs. 100 in 5 years, but A gives earnings of Rs. 20 for each of the 5 years, and B gives the earning of Rs. 100 only in the 5th year. NPV of A’s earnings is Rs. 84.25 and B’s is Rs. 74.73. Increase the rate to 8 per cent, A’s NPV is Rs. 79.85 and B’s, Rs. 68.06.
Veena: A’s NPV reduces by 5.2 per cent, while decline for B at 8.9 per cent due to the 2 per cent interest rate increase?
Ram: Bingo! Hence, growth stocks are under pressure.