Source: New York Federal Reserve
For the first time since 2018, the Federal Reserve increased the Federal Funds Rate. They only raised their target range a quarter point to 0.25%-to-0.50%, but they have since made myriad speeches pledging their commitment to raise rates further. The market has been listening and now expects the Federal Reserve to raise rates considerably to between 2.50% and 3.00% by the end of Q1 2023.
Rising interest rates will have profound impacts on all markets around the world. This blog post will consider the impact of rising rates on the stock market.
Owning stocks essentially gives you ownership of a company’s future cash flows. A $1 earned 10 years from now is worth some amount less than $1 today. The higher the discount rate, the less that future $1 is worth. A good yardstick to use when discounting is the 10-year US Treasury yield.
Further, as interest rates rise, it becomes more expensive for companies like Apple to borrow to buyback stock. And companies that issue debt for acquisitions or capital projects also see their costs, and hurdle rates, rise.
The Federal Reserve only controls short term interest rates but impacts long term rates as well. If the market is correct and the Fed Funds rate rises to 2.5%, for example, US-10 Year Treasury bonds should yield higher than that, most likely around 5%.
What will happen to stocks using a 5% discount rate? To make things less abstract, we decided to answer the question by looking at some of the FANG stocks. Helpfully, the Dean of Valuation, and fellow San Diego resident, Aswath Damodaran, recently updated his valuations of Amazon, Apple, and Google. We encourage interested readers to check out his post, linked here. What happens to the valuations produced by his discounted cash flow models if we change nothing but the discount rate? Please see the table below:
As you can see, by Damodaran’s calculations, Amazon is either undervalued, fairly valued, or slightly over-valued, depending on where the US-10 Year yield settles. Apple is 25% overvalued in a world with a 5% interest rate. And there are reasonable odds that we are in that world in one year’s time.
Usually, when adjusting the discount rate, we would also want to change our growth assumptions. Historically, the two have been related. As Jeffrey Gundlach at Doubleline pointed out, the 10-year yield used to track nominal GDP growth well. So, a 4% nominal GDP growth rate was matched by a 4% 10-Year US Treasury Yield. But interest rates have been kept artificially low as part of Fed policy, so rates need to catch up to “normal." In this case, rising rates will not correlate with a boost to growth.
As a response to the 2008 Great Financial Crisis, the Fed sought to create what former Chairman Ben Bernanke coined “the portfolio effect.” He wanted to reduce the returns on bonds to force investors to take more risk, providing a direct boost to stocks and home prices. Ultimately, the hope was that this wealth creation would “trickle down” into the real economy.
While the economic benefit of this policy was always dubious, the benefit to asset markets has been huge. As this policy comes to an end, it’s only natural to expect some of these gains to go in reverse.