February 2021: The role of interest rates in equity valuations

The strength in equity markets, despite the devastating effects of covid on the economy, can be directly linked to the loose monetary policies of various central banks and the fiscal stimulus provided by the governments. This has been repeated several times in the past that whenever we face recessionary conditions, central banks have stepped up and loosened monetary conditions significantly to cushion the impact of the recession. This essentially means availability of a lot of extra liquidity and low interest rates. This has also often been accompanied by fiscal stimulus from the government. This helps get demand back, reduces job losses, etc in the short term.

In India too, we have seen the government run a record high fiscal deficit – led by lower tax collections and higher spending by the government, to get the economy back on its feet. The RBI has also cut interest rates significantly and the repo rate is now at the lowest in its history at 4%. These lower rates have likely contributed to increased consumer demand over the last few quarters. Lower rates also can help boost investment because it lowers the hurdle rate that a project needs to cross to be considered viable. In the face of the unprecedented decline in economic growth during the covid lockdowns, the large monetary and fiscal stimulus was perhaps necessary given the situation.

Interest rates also play an important part in the valuation of equities. The intrinsic value of a company can be defined as the sum total of all free cash flows that can be derived from the business until eternity, discounted at an appropriate discount rate. The prevailing interest rate in the economy has a strong linkage with this discount rate and Warren Buffett has said that he uses the risk free rate (the yield on long term government bonds) because he expects clockwork like certainty of cash flows from the businesses that he invests in. One can choose some premium to the risk free rate depending on how certain one is about the free cash flows from the business one is investing in. Thus, there is a good inverse linkage between interest rates and equity valuations ie the lower is the interest rate, the higher the theoretical valuation of any company.

One needs to be cautious with this thesis though, because interest rates are not static and can move in a volatile fashion. We got a glimpse of this towards the end of February when global markets corrected violently in response to the jump in the US 10 year bond yield to 1.6% (it had gone to as low as 0.3% in March 2020 and was at 0.9% as on December 31, 2020). The spike in bond yields could be because of the prospect of increased inflation in the US post vaccination for covid. As things slowly get back to normal post vaccination, the economy is expected to recover strongly and given all the stimulus, both monetary as well as fiscal, this may stoke inflation. While the US Fed has maintained that it would be willing to tolerate higher rates of inflation and will likely keep an accommodative stance, a large increase in the bond yields could force the Fed’s hand,

Predicting interest rate movements is very hard to do consistently and we as investors try to stay away from this minefield. We would rather spend our time focusing on the performance of the businesses we own, their competitive position in the market place and the valuations that they are trading at, with respect to their history. This has worked well for us in the past and we hope not to deviate from this in the future also.