How Interest Rates Can Affect the Stock Market Part 2

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In my part one on this topic, I talked about how interest rates affect competing financial assets. That is basically relative to ones appeal. It is not the level of rates that is important, but their rate of change because this has bigger influence on profits and equity prices.

The most important effect interest rate changes has in my opinion is on corporate profits. Majority of the listed companies do leveraging, they borrow money to finance whatever inventory that they need. This means that interest rates changes can affect companies directly. 

In the other side of the spectrum, most of the companies which sells expensive items(like car companies, property developers, construction companies) have their sales substantially financed by borrowing. The change in interest rates therefore plays a crucial role in the influence on the willingness and ability of the customers to make additional purchases. A good example to have is automobile stocks, both the producers and consumers are very heavily financed, so ultimately, the change in interest rates will drastically affect stocks in those kind of sectors.

There is also the indirect effect of interest rates changes on corporate profits. Most people would know that tight monetary policy is correlated to rising rates which adversely affects business conditions, whereas falling rates stimulate the economy.

Higher rates and smaller profits means lower price/earnings multiples and therefore lower stock prices. Given time, the authorities will notice the negative effect on the economy and when they lower short term rates, a reverse will usually happen. Why would higher interest rates lower profits? Well businesses can be adaptive in nature, they can adjust to the higher interest rates, but when the change is sudden and unexpected, most businesses will resort to cutting of inventories and expansion plans which will ultimately affect corporate profits.

In the stock market front, there is also this thing called margin debt. It is basically money loaned by the brokerages for which securities are pledged as collateral. An increase in interest rates can therefore be correlated to the reluctance of the margin account holder to take on additional debt. When the charges becomes too much, margin calls happen which means stocks are liquidated to pay off the debt. Rising interest rates can have the effect of increasing the supply of stock put up for sale which leads to the downward pressure on prices.

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