The spread of the deadly coronavirus impacted not only the day-to-day lives of everyone, but was just as harmful to the economy. Economic activity came to a grinding halt and the monetary policy strategy employed by many countries to reinvigorate the economy was to cut interest rates. Now that the situation has stabilized, interest rates are on the rise to counter the growing inflation.
It might not be immediately obvious to some people how interest rates impact the stock market, but they are interconnected. The central bank’s decision regarding the interest rates has a ripple effect that significantly impacts the stock market. Firstly, it makes borrowing money expensive, and secondly, it raises the return on low-risk investments such as money market funds and bonds.
In light of this change, investors immediately start exploring and modifying their investment decisions (e.g. T-Bills suddenly became popular). Questions like which sectors are optimal in this economic scenario and which sectors to steer clear from, start popping up, and this article seeks to address these questions.
The financial sector is usually very sensitive to changes in interest rates. Higher interest rates are generally favorable for institutions like banks, brokerage firms, money managers, and insurance companies. As interest rates surge, the Net Interest Margin of these firms starts to expand and so the Net Interest Income gains in size.
The Net Interest Margin (NIM) refers to the net return on the bank’s earning assets, which include investment securities, loans, and leases. It is calculated using the interest income minus interest expense divided by earning assets. As such, a higher NIM indicates that the bank is having a higher net return on its assets. This signifies an overall increase in the profit margin, which is translated into the shareholder’s wealth as well.
Even though high interest rates over the long term will curb demand and slow down activity due to the higher cost of borrowing, initially, they symbolize booming economic activity and a healthy economy. A healthy economy means ample investment activity which benefits brokers. Creditors are also more likely to repay loans and so there are fewer non-performing assets for banks.
Likewise, it has been evident that the relationship between insurance companies and interest rates in the economy is linear. As seen from the image above, we can see that as the risk-free rates fall, the average P/E multiple falls as well, signifying a cheaper valuation for insurance companies. This is because in a low-rate environment, the underlying bond investments of insurance companies yield lower returns.
This makes the financial sector a lucrative area in times of high interest rates.
Conversely, the technology sector is infamous for being negatively affected by rising interest rates. To understand this, it’s imperative to realize tech stocks usually identify as growth stocks, as the technology industry has immense potential for growth. The concept of “discounted cash flows” is required to connect these dots; with high interest rates, the present value of future cash flows of these companies are lowered, and with it, investors’ interest in the stock.
Tech stocks usually have a high price-to-earnings ratio, and when bond yields are high, the idea of large returns in the distant future is not as attractive as shorter term gains and investors flock towards bonds or value stocks instead of high-cost tech stocks.
The cost of debt for these companies increases, which hampers their reinvestment opportunities and stunts growth and innovation prospects which are crucial for their sustainability.
But this principle that “higher interest rates are harmful for tech stocks” is not accepted holistically. The relationship between the tech sector and interest rates is being questioned by research and strategic studies.
Quantitative research studies on the correlation between interest rates and tech stocks state that there is little to no correlation. Cognitive biases might be blamed for this widespread misinformation about the animosity between the technology sector and rising interest rates.
How to find stocks within these 2 sectors?
An easy way to search for stocks in a sector is by using StocksCafe’s sorted sector list feature. You can even search through the different exchanges available in StocksCafe as well. The list is quite extensive with sub-industries within each sector that are also sorted as well.
If we were to go into the Financials sector, we would be greeted with a huge dataset of all the companies listed in the exchange selected, which in this case is the US exchange. You can see the company name, symbol, main sector, as well as the sub-industry that they belong to such as “Regional Banks”, “Asset Management & Custody Banks”, etc.
In summary, with the rising interest rates, the financial sector, as well as the technology sector, are 2 key sectors to watch out for, with one being a key beneficiary while the other being negatively impacted. Despite this, it could signal a cheap buying opportunity for tech companies that are proven to do well over the long term, based on their track record over the past few years.
Disclaimer: The content in this article (the “Information”) is not and shall not be construed as investment advice. This Information is meant to be informative and for general purposes only. Investment involves risk. Past performance is not indicative of future performance. Investors should refer to the offering documentation of the product(s) for detailed information (including risk factors) prior to investing in the product(s). If you have any query on the above information or any product offering documentation, you should seek independent professional advice.