Opinion – Grain in Grain: Why does the possibility of rising interest rates affect the stock markets so much?

Last Friday we saw the Brazilian and American stock markets showing strong devaluation. The main market agents justified this devaluation by the perspective of the Federal Reserve (FED, American Central Bank) raising interest rates stronger than previously expected. But why would the simple rise in interest rates affect the markets so much?

We can list at least four factors that cause equity markets to be affected by interest rates.

The first is the way of calculating the fair value of a share. Usually, the value is calculated using the discounted cash flow method. In this methodology, the company’s cash flows would be brought to present value by an interest rate.

In fact, contrary to what many people think, analysts do not use the Selic rate or the Fed Funds (US short-term interest rates) for stock pricing. The interest rate used by analysts is usually the 10-year bond rate. However, the basic interest rate of the economy, defined by the Central Banks, plays a fundamental role in the construction of the entire yield curve.

In a simplified way, in this method, a company flow, for example, dividends, is divided by an interest rate. Thus, as the interest rate in the valuation is in the denominator, the higher this rate, the lower the fair value for the company today.

The second reason is related to the opportunity cost of investors. With a higher interest rate, investors demand a higher return to take on risk. Therefore, considering the same fair value that the share price would converge in a year, the value to be paid for a share today should be lower in order to gain more on the investment.

The higher interest rate also affects corporate earnings in at least two ways.

First, with higher interest rates, companies’ financial expenses rise. So with a higher financial expense, the profit drops. So, as dividends are a proportion of profits, profits fall.

Finally, the sales of companies may be affected, that is, they may fall, as the cost of credit for people to consume rises. With higher consumption costs, they can postpone their purchases. Individuals can also postpone their purchases, as with higher returns on fixed-income securities, they are more attracted to them, exchanging consumption for investment in the short term.

For these reasons, it is not for nothing that analysts explain that interest rates are the forming element of all prices in the financial market.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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