The Reserve Bank of India examines interest rates atleast once a quarter. In this post, we examine the direct impact of RBI Interest Rates changes on some sectors and stocks. This assessment is likely to present profitable buy and sell opportunities on account of the interest rate changes.
RBI Interest Rates and the Stock Markets
On a general level, an interest rate increase dampens the mood of the stock market. This happens due to higher borrowing costs for the business sector and a potential drop in consumption by end consumers.
The immediate effect on businesses is a cutback on expansion programs which reduces growth potential. This is not taken lightly by the investor community. Additionally, there is every possibility of a drop in profitability with higher borrowing costs and lower revenue.
On the other hand, a reduction in interest rate should provide stimulus for businesses to borrow and invest more in building capacity. It is also a sign for end consumers to buy goods and services with easily and cheaply available credit. Investors love capacities and consumer demand – these improve future cash which spruces up the stock prices.
The Shock & Awe Approach by Stock Market
In the stock markets, rising or falling RBI interest rates and its impact is a function of the investors’ psychology. While it is true that businesses and consumers should react positively or adversely to interest rate changes, the stock market does not really react in the same manner.
The reactions in the stock market is a lot about perceptions.
Let’s say the stock market was expecting a 50 bps cut in RBI interest rates, but the central bank “disappointed” by reducing the rate by only 25 bps. This will lead to a fall in the broader index as the 50 bps drop was already baked into the existing price.
I love this Gordan Gecko quote
To conclude – the relationship between interest rates and stock market movements is rather indirect. They tend to move in opposite directions as a rule of thumb. So when the interest rates are cut, the stock market goes up. And when the interest rates climb, the stock market goes down.
But remember, the economy takes upto an year (sometimes two) to get any impact of the interest change. This is called a lag. And then there is the matter of stock market perceptions on the direction of interest rates. Given these factors, there is no guarantee how the market will react to any interest rate change.
Impact on Specific Sectors and Companies
Theoretically, higher RBI interest rates should mean lower valuations. This is due to the workings of the discounted cash flow (DCF) model where a higher interest rate increases the discount rate used in the model.
Higher the discount rate used, lower will be future cash flow of the business. And lower the future cash flow, lower will be the valuations.
For more information on DCF, watch this video on discounted cash flow valuation method
All companies are not cut from the same cloth. Interestingly, for some companies a higher interest rate is beneficial. And for some companies, a higher interest rate is to their disadvantage.
Let’s spend a little time on this
Like we said earlier, higher interest rate will increase borrowing costs but that’s for companies who need to borrow. While this tends to spook the broader market, it is good news for businesses who already have enough cash reserves.
And here in lies an opportunity to pick up stocks in some businesses at reasonable valuations.
Since cash-rich companies don’t have to borrow, their future cash flows will not be impacted due to interest costs. Additionally, the fact that their competitors cash flow will be hurt due to a higher interest rate will help improve the cash-rich company’s stock prices in the future.
Impact on automobile and real estate sector
Two more sectors which have a direct impact of RBI interest rates are the automobile and the real estate sector. It is very logical that car loan and home loan applications will fall in an environment of high interest rates. This will have an effect on the car loan and home loan companies.
Thus we see that interest changes are beneficial for some companies and detrimental to others.
Remember, it usually takes about 3 to 4 quarters for any increase or decrease in interest rates to be felt in a widespread economic way. However the stock market responds to it almost immediately which can create some interesting opportunities
Stocks and Sectors that Benefit from Interest Rate Hikes
Banks make money by “buying” deposits cheaply and “selling” them at much higher prices.
The buying deposits refer to savings accounts and fixed deposits. Everyday consumers park their money safely in them and earn some interest on it. In India, the savings bank interest rate is between 3.5% and 4% for most banks. Fixed deposits currently pay between 6% to 7% per annum.
“Selling” from a bank’s perspective refers to deploying the money received from deposits as loans to consumers. These loans extend from business loans, personal loans, home loans, auto loans etc. Loans, depending on the riskiness of the borrower are mostly priced between 10% to 25%.
The difference between the average loan rate and the average deposit rate is called the bank’s “net interest margin”. The net interest margin (NIM) is a big part of a bank’s profits. Generally, banks endeavour for an NIM of between 3.0-3.5%. HDFC Bank has been maintaining an NIM of between 4.3-4.4% for the last three years.
When the RBI hikes the interest rate, banks immediately raise the lending rate. However there is almost no change to the savings rate.
Think about it. How often has the bank raised it’s savings rate when the RBI has increased the base rate? Almost never!
Savings account is where the bulk of idle deposits are and remain the most profitable source of funds for them. Banks continue to offer very low savings rate to the depositors and now can charge even higher rates of interest to the loan borrowers. This increases the profitability of banks as a direct result of the increase in interest rates.
2. Stock Brokerages
Brokerage firms earn revenue from the interest earned on balances held in client accounts. This is popularly referred to as “float”. When the interest rates go higher, the brokerages are able to make more money on the float that is available with them.
Even a 0.5% increase in the interest rates can massively bump up the profitability of equity brokers. Additionally, brokerages get a lift in profitability as a healthy economy sees more investment activity in the share markets.
3. Insurance companies
In the Indian environment, insurance companies make less money on underwriting and make more money on the investment income. Investment income is the interest or returns earned by insurance companies on the premium deposited by their customers.
In a high interest environment, insurance companies get more returns on their bond investments. This gives a good lift to their profitability.
But RBI interest rates affect the prices of bonds. So won’t an increase in interest rate reduce the bond prices?
This is a good question and here’s the answer.
Insurers invest in bonds which are generally held to maturity. By holding till maturity, the insurance company is not bothered by bond prices. Their only care is about the yield and safety of the bond they have invested in.
Additionally, strong economic activity also improves consumer sentiments. This leads to more auto insurance and home insurance policies being written on account of more car and home sales.
4. Technology and Healthcare Stocks
Technology and healthcare businesses hold a high percentage of their profits as retained earnings. They do this to reinvest this month in the company’s growth rather than paying them out as dividend. This move often attracts the ire of the investment community.
The biggest chunk of sitting-on-cash corporations are in Japan. Companies listed in Japan held over ¥500 trillion ($5 trillion) in cash per their latest filing in 2019. That’s $5 trillion of money receiving no interest as interest rates in Japan are zero.
In times of a rising interest rate, these cash reserves lead to higher yield on their investments which improves profitability.
5. Payroll Processing Companies
Payroll processors maintain large cash balances on behalf of customers in the periods between paychecks. This “float” fetches a higher return when interest rate go up. As a result, the revenue and profitability of the payroll processing companies improves.
6. High Dividend Stocks
As interest rates go up, there is pressure on stocks that offer dividends. This is the case because of the improvement in bond yields. Stocks which provide very high dividends (higher than the interest offered by AAA bonds) are in much demand which ups the price of these stocks. The case for this gets stronger if these companies are growing their dividend each year.
7. Consumer Discretionary Businesses
The economy is doing well and this bores well for companies that sell discretionary products like cars, homes, casinos etc. A higher interest rate is the result of a pickup in economic activity and growth. This exuberance results in higher levels of employment, more money flowing through the system, higher job security, better wage growth and consequently, a higher level of spending. The stock price of these business go up when this happens.
Sectors that Benefit from Lower RBI Interest Rates
8. Dividend paying sectors
Stocks of utility companies (electricity, natural gas, oil, power lines etc.) often trade like bonds. The stock price of these companies are highly sensitive to high interest rates. They tend to struggle in a high interest rate environment as investors prefer to purchase lower-risk bonds with stronger yields as compared to riskier stocks inspite of high dividend yields.
Thus, in a low interest environment, investors are happy to pay a premium for high dividend yielding businesses. This drive up the stock prices of such stocks. Further, as the interest outgo on the debt of the utilities goes down, it improves the profitability. This further supports an push-up in stock prices due to better interest coverage ratios.
9. Real estate companies
Housing becomes affordable to millions of Indian with a reduction in interest rates. Housing is not only a big infrastructure play but an aspiration to the everyday person. A reduction in rates is welcomed by most as the sector generates huge employment.
Lower interest rates transforms to more real estate deals and sale of houses. This period normally sees a number of first-time home buyers applications enter the market. The profits of housing companies go up during this period.
10. Car loan companies
With over 80% of cars bought in India being financed, a low interest rate environment is highly favourable. There are more car sales which produces higher profits for the companies.
The inverse relationship between interest rates and bond prices is a useful area of study as it helps you in better understanding opportunities in the bond market.
Learnings for investors from RBI interest rates changes
Interest rate changes offer multiple opportunities to investors. These include higher predictably on which direction stocks, bonds and mutual funds are likely to move.
We have shown in this post that some sectors tend to improve and some decelerate on account of interest rate changes. Use this information to buy favourable stocks. And also make good of this information to rejig your position and exit out of unfavourable stocks.
On the debt side, there is a more direct correlation between bond prices, bond yields and interest rates. If interest rates go down, the bond prices go up – which can offer you a timely opportunity to sell bonds and reinvest the money in other financial instruments. And if interest rates were to go up, you might want to relook at the asset allocation mix you currently hold.
Interest rate changes happen more frequently now that earlier especially in a developing market like India which is integrating with the global economy had a fast pace.
India’s economy is expected to have the high growth rate from among the top 20 nations of the world. India has just broken into top 5 economies of the world with a $2.70 trillion GDP. This brings added interest to market participants with regards to RBI interest rates.
Interest rates are the ‘most important’ thing in determining stock valuesWarren Buffett