The Effect Inflation and Interest Rates on Global Equities

April 20, 2017
Writer(s): Daniel Pederick, Oliver Thorne, Patricia Nunga, Sarah Tan

Background on Interest Rates and Inflation

Throughout history, economists have been divided over finding an effective response to the constantly changing nature of inflation and interest rates. However, present policy-making in many dynamic economics reveals that there is a sort consensus that forces of supply and demand influence changes in inflation, which in turn moves concurrently with changes in interest rates. For instance, during the Global Financial Crisis (GFC), the USA experienced a recession that prompted a period of stagnation, accompanied by low short-term rates that swiftly fell below 5% between 2005 and 2010, which is supported by the trends in Figure 1.1.

Figure 1.1. Changes in Interest Rates (1995-2015)

(Cochrane, 2015)

What do these interest rates reveal?

This time series demonstrates the causal relationship of interest rates and inflation. When an economy is in prolonged periods of low or declining growth, interest rates may be decreased by the central bank as monetary policy to encourage consumer spending and borrowing. These interest rates are seen to rise as the economy recovers and stabilizes, as consumers regain confidence in the investing environment. However, such increases in rates can also have varying impacts on stock returns and equities. For instance, since the Great Depression, research posits that nearly every economy struggled with egregious real returns on equities during inflation peaks; studying historical data suggest returns are most profitable when inflation remains at 2-3% (Zucchi, n.d.). This instability likely imparts disquietude over larger issues within the economy. Considering the nearly 3% hike in the US Consumer Price Index from January 2016, evident in Figure 1.2, large investment banks like Bank of America are still expressing optimism in its recent Global Research for 2017, predicting greater investor opportunity, modest gains, and higher investment yields (newsroom.bankofamerica.com, 2016).

Figure 1.2. Consumer Price Index (January 2010-January 2017)

(Walayat, 2017)

How has this affected global equities?

Over the past 10 years, global equities have reached historical highs. However, there have been growing concerns about the source and the sustainability of this rise over the past decade since the Global Financial Crisis (GFC). Following the GFC, many advanced OECD economies, most notably the United States’ Federal Reserve (Fed) and the European Union’s ECB, has engaged in quantitative easing (QE). QE is a monetary policy where the central bank creates electronic money to buy government bonds or other financial assets, such as global equities, to stimulate the economy (bankofengland.co.uk, n.d.). The theory is that this increase in investment will lead to a virtuous counter-cyclical effect against an impending recession. This led to concerns that it caused an indiscriminate allocation of money into global equities against traditional valuation metrics such as the P/E ratio or future prospects of a company from observing their management and broader industry trends.

It has been estimated that there is a 93% correlation between the Fed’s QE activities and the broader stock market movements within the United States (Lewitinn, 2016). The indiscriminate allocation of money also extends to private individuals and institutional investors such as sovereign wealth funds, pension funds and mutual index funds. Alongside QE, central banks in OECD economies also engaged in expansionary monetary policy by reducing the interest rate to 0% (global-rates.com, 2017). Economic theory suggests that as the cash rate is lowered, retail banks will be forced pass on the reduction in the form of cheaper loans and consumers will be discouraged from saving. This would lead to an increase in aggregate demand, thereby stimulating the economy.

However, as interest rates decrease, the real return on investment increases ceteris paribus. Thus, more investors were encouraged to invest their money into what would’ve been considered poor investments given the cost of borrowing previously. Thus, it could be considered that it led to overinvestment in relatively poorer quality investment vehicles with little prospect for high returns and future growth, which could have an impact on future economic growth.

What does this mean for the future of global equities?

Figure 1.3. Trend of the US Fed Funds Rate (April 2016-Present)

(tradingeconomics.com, 2017)

A rise in the interest rates by the Fed as shown in the chart above, has an indirect negative impact on stock markets with stock prices falling in the global market (Investopedia, 2017). This is because a rise in the interest rates by the Fed causes a ripple effect on borrowing costs as banks increase prime rates (credit rates that banks extend to their most credit-worthy customers) and credit card rates – more so for short-term borrowing compared to long-term borrowing. Due to the rise in borrowing costs, consumers end up having a lower disposable income, which results in a downturn in consumer impulse spending and encourages those with debt burdens to pay off their financial obligations quickly before interest rates rise further in the future.

A downturn in consumer spending could affect business profits around the world. Excluding the profitability of the banking sector, profitability of other global business sectors take a hit as capital cost increases which eats into the businesses’ earnings, thus effecting the profits of these businesses (Baldwin, 2017). The reduction of disposable income for these businesses means that a cutting of any disposable costs on equipment or labour occurs as the overall amount of these costs are constrained as much as possible to condense the effect of these costs on the productivity of these businesses in the long-term.

Besides that, higher interest rates may fuel an increase in national debt as borrowing costs increases which could lead to an increase in inflation particularly if the rise in government spending exceeds the fall of national consumption for an economy. This raises warning signs for governments with high levels of debt as they consider the principal and interest amounts that must be paid back in the future.

Having said that however, a fall of the stock prices in the global market could allow for more productive investments to emerge in the global equity market. This in turn would allow investors the opportunity to carefully and thoroughly evaluate the conditions of the investments available and choose those which generate the highest returns (Seabury, 2017). This would mean that there is potential for future growth of the global equity market – good news for existing and potential investors with these rising interest rates.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.