Why higher interest rates would mean lower share prices

Sharemarket "experts" have an opinion on everything - especially economics. Opining on the latest macroeconomic data both boosts the ego and makes us sound smart.

And the beauty is that you can take any piece of data you like and make it fit your world view. Interest rates are down? That's great, because people will be able to spend more. Unless you've already decided you're bearish, in which case lower rates are a disaster because it shows how weak the economy is.

Higher rates, of course, are great, because it shows the economy is standing on its own two feet and can withstand higher rates ... or terrible, because it'll affect spending and business investment.

Higher oil prices? Great! It boosts GDP and inflation. Or, terrible, because we have less money to spend on other things. Quantitative easing was either desperate and hyperinflationary, or restored much needed confidence. A higher dollar either hollows out manufacturing or gives Australians greater purchasing power by making imports more affordable. A lower dollar is either great for our farmers and tourism operators or terrible for importers and travellers.

I jest, of course. At least ... a little.

But back to interest rates. Regardless of your pre-existing world view, investors fret about the RBA's actions mostly because of the impact those decisions will have on consumer spending and business investment. Which makes sense - if central bankers stoke economic activity, it stands to reason that companies will make more money. If they turn down the burners, sales and profits would likely feel an impact.

But there's a bigger and much more important issue at play - as it comes down to the algebra that most market participants use to work out whether a company's shares are cheap or expensive.

In short, finance theory suggests that an asset is only ever worth the money you can get from it. That's the dividends, rent or interest, plus the future asset value if you sell. Then, that theory says - rightly - that a dollar in five years is worth less than a dollar today. After all, if the amount of money is the same, I'll take it now. We invest - foregoing today's spending - to have more money in the future.

But - and here's the thing - when working out how much less those future dollars are, investors use what's called a "discount rate". Only a little more jargon, then we're done: it's usually calculated by adding a "risk premium" - how much extra you want to earn, given the risk of investing in shares - to the "risk-free rate". And here's why that matters: the risk-free rate is typically based off a government bond ... which itself is priced with reference to the Reserve Bank's official cash rate.

OK, that's enough econospeak.

Here's why that matters: the longer interest rates stay low, the more you can afford to pay for a company's shares - pushing share prices up. But as rates steadily increase - and they will, at some point - investors will start to ratchet back the prices they'll pay. Because the way the maths works, a higher discount rate means lower share prices.

More plainly, earlier this year Warren Buffett said: "If we get back to normal interest rates, stocks at these prices will look high." He added "If we continue with these interest rates, stocks will look very cheap."

Foolish takeaway

The Reserve Bank absolutely has a big impact - especially over longer time periods - on the physical economy. It affects jobs and growth (not our legislators), in the process influencing consumer spending and company profits. But for investors, the bigger impact is on how much you should pay for those profits - now and in future.

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Scott Phillips is the Motley Fool's director of research. You can follow Scott on Twitter @TMFScottP or email ScottTheFool@gmail.com. The Motley Fool's purpose is to educate, amuse and enrich investors.

The story Why higher interest rates would mean lower share prices first appeared on The Sydney Morning Herald.

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