How do interest rates impact global stock indices?

On May 3, 2023 the Federal Open Market Committee (FOMC) will announce the outcome of its meeting to decide whether to maintain interest rates or increase it. This meeting will be critical, as traders all over the world will be keenly watching it. After all, a small change in interest rates can materially change the way stock markets will move. Within minutes of the announcement of its decision, global stock indices move swiftly in response to changes in interest rates. Given this, it is vital to understand the close link between interest rates and its impact on global indices. This will help understand unexpected volatilities in markets.

One of the most revered investment gurus Warren Buffett once explained precisely in a few words the significance of interest rates. He had said, “Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on the asset prices.” This gives an idea of how interest rates play a crucial role in markets.

Low interest rates and economy

Low interest rates mean that money is available freely and in abundance. Traders and investors can borrow money quickly and deploy it in stocks. In such a situation, no wonder traders and investors make bold decisions. As a result of this, markets move up. There is another reason why investors also chase stocks in times when interest rates are low. When bonds start offering lower yields, the overall returns on portfolios go down. In such a situation, investors look for means to enhance portfolios’ returns. A simple way to achieve this is to allocate more money to stocks. Again, markets rise when there is higher allocation to stocks in times when interest rates tread lower. These are broad patterns in markets when interest rates are low.

In addition to these, there are a few fundamental factors that impact indices in general. Let us understand them in greater detail:

Low interest rate regime brings down the cost of funds for companies. Companies save on interest expenses to a certain extent which increases their profits. As profits soar, earnings per share of companies rise and investors are rewarded in the medium term with high dividends. Naturally, more investors are willing to pay higher prices for stocks with increased earnings. Low interest rate regime also makes more entrepreneurs confident. More greenfield projects are announced, and money is raised. Even existing companies choose to expand with borrowed money. Such expansion ideas lead to more capital expenditures and a cycle of rising corporate profits begins. Stocks in general start going up which lifts stock indices.

Though a low-interest rate regime appears to be an advantageous thing for most stock markets, it comes with a challenge called inflation. As a result, central banks raise interest rates to tame inflation. All these factors which worked in a particular direction when interest rates are going down, take a U-turn in case of rapid increase in interest rates. Typically, in an expanding economy interest rates start going up. If the pace of increase and quantum of increase is manageable, investors do not lose much. But if interest rates are hiked quickly, then it pulls down stock prices and subsequently, stock indices. For example, an approximately 500 basis point increase in policy rates since the beginning of CY2022 has pulled down the S&P 500 index by 19 per cent in 2022.

It must be noted here that interest rates are hiked not only to tame inflation but also to protect the currency of a country. By hiking interest rates, a country can invite capital. Capital inflows typically strengthen the currency of a country with higher interest rates in the short term. Take for instance, Brazil. Brazil has been aggressively hiking interest rates ahead of the US Federal Reserve. Generally, markets in Brazil should have been under pressure when the US Federal Reserve went on a rate hike spree. But the more aggressive stance taken by the Brazilian authorities on interest rates, along with other factors, has ensured that IBX50 – Bovespa Brazil 50 index gained 5.71 per cent in 2022.

Conclusion

While different countries’ stocks may get affected in different ways, even in one country all stock indices are not impacted to the same extent. It is very much known to savvy investors that small-cap stock indices that house smaller companies are impacted more when interest rates are hiked in comparison with large-sized companies. Also, when liquidity is unleashed and interest rates are hiked, small-cap indices move up the most. When interest rates rise, typically value-based indices tend to outperform their momentum-based counterparts, and the other way around also holds good.

Given these reasons, changes in interest rates need to be tracked and analyzed. This will give you an idea of the movements in stock indices in the future.