Why interest rates are so important to share prices

• Central bank interest rates influence the return available from lower-risk asset classes such as cash and bonds
• Ten-year government bond yields are seen as the 'risk-free rate' and any other investment should return more than that to compensate for the additional risks
• The higher the risk-free rate yield goes, the less inclined, or obliged, investors may feel to take risk and pay up for other asset classes, such as shares (and vice-versa), so rates affect the 'P' in the P/E (price to earnings ratio)
• The cost of money also affects activity in the real economy - and therefore corporate earnings, or the 'E' in the P/E ratio

"Fears that interest rates will stay higher for longer, as inflation stubbornly does the same, mean the yield on government bonds are also refusing to go down and that in turn is starting to put a little pressure on share prices," says AJ Bell investment director Russ Mould. "This is partly because investors can grab a higher yield on certain UK gilts or US Treasuries than they can from headline share indices and do so for less risk, at least in theory.

Source: LSEG Datastream data

"Central banks are still grappling with inflation and trying to get it back to their 2% targets. Higher interest rates (and ongoing Quantitative Tightening programmes, for that matter) are designed to cool the economy, so inflation does not take a hold.

"Reaching that 2% inflation target may not be easy. Fifteen years of ultra-loose unorthodox monetary policy, in the form of zero interest rate policies (ZIRP) and Quantitative Easing (QE), with a good dollop of fiscal stimulus during Covid-19 and lockdowns on top, could well take some reversing.

"It may be that inflation and higher interest rates are the bill for that period of largesse, with equally unpleasant alternatives being tax increases or currency weakness (a path which Japan continues to take, looking at how the yen stands at thirty-four-year lows against the US dollar). Either way, the 4.27% yield on UK ten-year gilts is the highest since last November and the paper is pushing toward 4.50% for only the third time since the Great Financial Crisis of 2008 (the others being the Trussonomics panic of autumn 2022 and the inflation scare of autumn 2023).

"Meanwhile, the US ten-year Treasury yield is moving back toward the 5% mark, a figure only reached once since 2007, and that was last October when, again, financial markets were running scared of inflation. Go further back, and these yields are actually pretty normal. It is only the last fifteen years that have been the aberration, even if for many investors they began to feel like a 'new normal'.

"But if bond markets are going back to normal, does this mean that the last fifteen years have been an aberration for share prices, cryptocurrencies, non-fungible tokens and other asset classes too? After all, many asset classes have thrived during an era of ultra-cheap money and the party has been huge. The test now is whether higher returns on cash and higher government bond yields tempt investors to take less risk and pay lower valuations and prices for riskier assets, because they may feel they do not need them quite so badly.

"Interest rate cuts could render all of this invalid, but government bond yields are currently rising as central banks back away from looser monetary policy. That is taking its toll on shares in so-called 'bond proxy' sectors such as utilities. Utilities do not grow their earnings quickly, as demand is fairly stable, and returns are regulated.

"As a result, their shares tend to offer plump yields to attract buyers and compensate them for the risks involved with holding the paper. But higher government bond yields may mean bond proxies look less attractive, on a relative basis, as government paper should offer less risk than shares in a company, since there is much less chance of default than there is a dividend cut.

Source: LSEG Datastream data

"But it is not just stodgy utilities that are feeling the heat from higher bond yields. Go-go technology stocks may be doing so, too.

"It would be a brave person to say the NASDAQ has peaked, but the tech-laden American index has just shed its last two months' gains as US Treasury yields have ground higher.

Source: LSEG Datastream data

"In both cases, the pressure has only just begun to tell, and this may be because interest rates are now positive in real terms - in other words, they exceed inflation.

"In addition, January's forecasts of six interest rate cuts, with the first in March from both the US Federal Reserve and the Bank of England, have been recalibrated, to just two reductions, with the first coming in August or September.

"This may not necessarily stop US equities going up, as the economy may be running hotter than thought and that could help corporate profits. But it might mean that the sectors who benefitted from the low-rate, low-growth, low-inflation murk of the 2010s may not do so well if the 2020s turn out to be an era of higher rates, higher nominal growth and higher inflation.

"An era of higher nominal growth and inflation could, if history is any guide, lead investors to prefer short-duration assets like cyclicals and hard assets like commodities over long-duration and growth secular sectors like tech as well as over paper assets like bonds. After all, investors are currently able to pay lower valuations for cyclical growth now than they are for secular growth later - and if there is lots of cyclical growth about because of inflation, then the need to pay a premium for long-term future growth is diminished.

"That could, in turn, favour miners (a sector out in the cold for most of the last decade) and hamper tech stocks (a sector that has been in favour for most of the past ten years). For some, the Magnificent Seven have been the only game in town, at least recently, but even this august septet has started to slow down a little, at least share-price wise.

"For the moment, the $700 billion drop in the combined market valuation of the Magnificent Seven is just a mere 5% retreat, but it will be interesting to see if it continues should markets continue to push back expectations for interest rate cuts.

"Should interest rates and bond yields stay elevated, then discount rates are likely to stay higher and that affects the discounted cash flow (DCF) valuations which are used for long-term growth companies, the bulk of whose profits and cash flows are some way off in the future.

"The discount rate is used to value future cash flows in today's money, by discounting back those expected cash flows at a given rate.

"The higher the discount rate, the less the future cash flows will be worth in today's money. That means a lower valuation for the equity and a lower theoretical share price, although the opposite holds true, too - the lower the discount rate, the higher the equity value and the higher the theoretical share price.

"This may be why a lengthy period of low or even negative bond yields prompted a huge uplift in the valuation of perceived growth companies, such as tech and biotech stocks, during the past decade, and why they, and the Magnificent Seven, have responded so favourably to hopes for interest rate cuts. Their earnings power is hard to second-guess (although Apple's recent lack of growth and Tesla's drop in deliveries are starting to raise some questions) but the price investors are willing to pay to access that growth - the 'p' in the price/earnings valuation calculation, or PE - could start to waver.

"That matters because price times earnings (P x E) equals share price, so earnings could still rise and the share price could fall, if the 'p' starts to drop. In the end, the PE is just shorthand for the DCF, so discount rates matter there, too."

The risk-free rate

"The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because, in principle, the government will not default on its liabilities. It will always be good to make the interest payments (or coupons) on time and return the initial investment (or principal) once the bond matures, even if it must print money to do so.

"Bear in mind that the yield on the bond will differ from the coupon, or interest rate, at its time of issue. This is because the bond's price will move over time. The running yield of the bond is calculated by dividing the annual coupon by the current price and expressing that as a percentage. The yield to maturity will adjust for any capital gain or loss after the purchase of the bond, since it will usually be redeemed upon maturity at its issue price.

"The last time the UK defaulted was 1672 and the Stop of Exchequer under King Charles II and as such as the ten-year UK government bond, or gilt, is seen as the risk-free rate for UK investors.

"At the time of writing, the ten-year gilt is yielding 4.27%. This is therefore the minimum nominal annual return on any investment that any investor should accept, since it is seen as risk-free (despite the tiny chance the UK does default, or the other challenges posed by movements in interest rates and inflation).

"Any other alternative investment carries more risk so the investor should demand more from them:

• Investment-grade corporate bonds should yield more than government bonds because companies can and do go bust and management teams can do silly things
• High-yield (or junk) corporate bonds should yield more than investment grade bonds because these firms are more indebted, and the risk of bankruptcy and default is higher
• Shares should offer the prospect of higher total returns than junk debt, because share prices go down as well as up, while a junk bond will offer pre-determined interest payments and return of the initial investment if all goes well

"The returns demanded by an investor to compensate themselves for the (additional) risks involved will therefore, in theory, move relative to the gilt yield and that in turn will be influenced by central bank-approved interest rates.

"If a central bank is raising interest rates, then the yield on existing government paper will look less attractive. Investors will sell them and look to buy newly issued gilts, which will have to come with a higher yield to attract buyers and help the government fund its spending needs.

"This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase. This means a higher yield on newly issued bonds or paying a lower price for existing bonds (as a lower price means a higher yield for bonds, just as it does for shares).

"For shares, it means paying a lower valuation, or multiple of earnings and cashflow, and also perhaps demanding a higher dividend yield (which is achieved by buying at a lower share price).

"Remember that the total return from a share is determined by capital return plus dividend yield and the capital return will be, in crude terms, the function of both earnings growth and the multiple paid to access that earnings growth. In its simplest form, this can be seen in the price/earnings (PE) ratio. Earnings will go up (or down), depending upon the business cycle and the company's target industry and acumen. The price, or multiple, paid can be affected by many things, including the company's finances, managerial competence and governance, as well as the predictability and reliability of its operations and financial performance.

"Interest rates will have a big say, too. If rates and gilt yields are rising, investors may feel less inclined or obliged to take more risk with shares and other asset classes if safer options are offering better returns, at least on a pre-inflation basis. As a result, they may decide to pay lower prices and multiples - a lower P for the E - and that is why stock markets can slide as rates rise, especially because someone still has to hold the shares. They do not just disappear, so the new owner has to make a judgement on what they are worth.

"For property, the same calculation will apply - the rental yield will be benchmarked against the safer options, in nominal terms at least, of cash and gilts and other bonds. New buildings will need to offer a higher rental yield to attract buyers, and that often means lower property values."