Interest rates are a fundamental input in any industry that utilises debt and has a material impact on any individual that has debts.
We are all hearing a lot about cost of living expenses and rising interest rates can be a big part of this.
The Reserve Bank sets the ‘cash rate’ that can impact the cost of borrowing for the government but for most businesses and individuals, your provider sets the rates and they are going up.
So what drives interest rates?
Like most things we spend money on, interest can be driven by demand and scarcity.
Deposits in your bank accounts can be on lent to borrowers – usually at a far higher rate than you are being paid.
However, Australian demand for borrowings are far higher than our deposit base so providers often have to source capital from overseas.
A lender won’t provide money unless they can see worthwhile return verses their risk of default.
We (being Australia), compete for this capital so we need to offer higher interest rates to attract the capital. Credit ratings, geopolitical stability and strength of currency all play their part.
Venezuela, as an example, has just seen its cash rate drop from 58.35% 01/01/22 to 56.18% on the 01/03/22 https://countryeconomy.com/key-rates/venezuela
Australia’s cash rate is at 0.10% which would give you an idea of relative risk. Access to capital is far cheaper at lower default risk.
Why would interest rate rises impact on share prices?
Companies use debt to acquire assets and grow their businesses. If they have substantial debts, any increase in rates impacts on their profit margins and unless they can pass those costs on to consumers, their profits will drop. Generally Australian companies are not as highly leveraged as their US counterparts who have definitely repeated the mistakes of their pre GFC forebears.
The word ‘generally’ ignores that while most might be good, there are always companies that have invested heavily via debt and are very sensitive to any rate rises.
Equity analysts use a metric called free cash flow and interest rate coverage when determining a company’s viability and yes, we have public companies that will have real problems if interest costs increase. Analysts talk about zombie companies that are surviving but only have enough profit to pay their interest expenses – these very quickly disappear in a rising rate environment.
But all companies with debt can be impacted by interest rate rises and even with no debt, their suppliers and distributors could be impacted by the debt they hold.
How about the consumer?
Cost of living increases in fuel and groceries reduces disposable income. Interest rates also impact on this. If interest rates rise consumers have less money to spend so will defer purchasing larger items like household goods as well as reduce their leisure time spending. They might also defer renovations or maintenance.
A very simple example of a $700,000 mortgage:
A current CBA variable rate of 4.5% would incur approximately $31,500 of interest expense. Usually, you would have both principal and interest but we will just talk interest.
$31,500 a year equates to $606 a week.
If interest rates rise by 0.5% this increases by $67 a week.
If interest rate rise by 1.0% this increases by $135 a week.
Taking $135 out of a normal family budget every week hurts and that is just with a 1% rise.
If the consumer reduces their spending and defers larger purchases this will also impact on company earnings.
Australian inflation is running at an annual rate of 5.1% based on the 31 March 2022 number. Some of this is supply chain issues but wages growth is also occurring due to very low levels of unemployment so employers are competing for human resources.
Wages growth also reduces profitability if those costs can’t be passed on and if you already have reduced spending due to things like mortgage rates it is hard to get the consumer to pay for the increased cost of wages.
All of this impacts on earnings growth and therefore the value of companies.
How to manage this.
The next ten years will not be the same as the last but that does not mean there aren’t opportunities.
Good quality companies with low debt and lots of free cash flow will still do very well and that is what we need from or active fund managers.
Property is a good inflation hedge but the recent increase in prices has probably brought forward a lot of the next three to four years growth.
Patience also needs play its part.
The geopolitical landscape is very unstable but we all know that. Free markets mean a lot of this uncertainty is already factored into current prices.
There is no rush to take risk in this market if you aren’t already in it and there is value in reducing risk if you are able and already invested.
You do need to be able to act when opportunities come up and that means having cash available to buy into negative markets.
Rising interest rates will have an impact and already has. Our job is to help you continue to build your wealth through it.
As always if you have any concerns, talk to us. We are here to help.