Revisiting the Relationship Between Interest Rates and Tech

In Theory

Interest rate is an important factor for investors and businesses as they rely on it for investment and increasing the capacity of production. Change in interest rate affects the profitability of companies which have an impact on dividend distribution to shareholders, which reflects in the stock price of the company. Also, in the case of high-interest rate, investors substitute stocks with interest-bearing financial assets because of that stock price falls. Cost of living increases due to the upward movement of inflation. This leads to low savings and reduces the demand for stocks, which leads to the price reduction (1).

According to the classical theory of asset prices, the price of an asset is equal to the present value of expected income from the asset. So, for a firm, stock prices represent the discounted present value of its future cash flows. Therefore, monetary policy decisions, closely associated with changes in various short-term interest rates, are expected to affect stock prices by adjusting the discount rate (2). Therefore, in theory, all else being equal, higher interest rates lead to lower stock prices as you discount future cash flows with a higher rate.

In Reality

In reality, stock market returns are much more complicated to predict. Interest rates definitely seem to impact short-term returns. Beneath the surface, the academic papers seem to overlook the faster economic and earnings growth that accompanies higher interest rates. From the 1970s to the early 1980s, the correlation was ambiguous, with the market Inching slightly higher in the decade amongst the incredible growth of Interest rates, as shown by the graph below. Throughout this period, there were 4 recessions.

However, throughout the 1980s and 1990s, a negative correlation seemed to develop between stock market returns and Interest rates. As rates began to drop, the stock market performed well through the entire decade. There were 0 recessions during this period.

Throughout the 1990s, the relationship became more ambiguous. The market rose consistently, but Interest rates rose and fell.

In recent times, the market has been uncorrelated to the rise and fall of interest rates.

In fact, there have been many times, when Interest rates rose and stocks followed as well. Historically, It seems that stocks are more likely to rise than fall In periods of increasing Interest rates. This tendency can also be seen when comparing changes in rates to changes in stock prices. Since 1995, in months when the U.S. 10-year treasury yield rose by more than 50 basis points (bps), over the following three months the S&P 500 posted a price gain of 3.2%, roughly 100 bps higher than a typical month (3).

The case for stocks and rates moving together is even stronger when comparing valuations to real interest rates (rates minus inflation expectations). Looking at data since the inception of the TIPS market, real rates and equity multiples typically have a strong positive relationship. In other words, higher real rates have been associated with higher multiples. Based on this relationship you would expect a 50 bps rise in real rates to be associated with equity multiples moving up by one point. While real life is unlikely to conform exactly to the model, the relationship illustrates that real rates and multiples generally move together (4).

There has been much said to the effect of technology stocks being the most impaired by interest rates rising. The theory here being that companies with no earnings are discounted more heavily as their future cash flows are more in danger. While this may seem true with recent performance of the technology sector, taking a look at overall performance seems to indicate otherwise.

Undoubtedly, low Interest rates provides an advantageous environment that allow certain unprofitable companies to grow more easily. However, higher Interest rate environments also bring about advantages that are overlooked or disregarded among much of the talk. In fact, many companies of the NASDAQ are currently profitable companies. The Industry has matured much over the last two decades and In fact brings about the most profitable companies In the world. While It is true over the last year, the correlation has been strongly negative, the trend, as looked upon with historical data, seems to be a short-term one.

The correlation has changed over time and in recent years has showed a more negative relationship. Nonetheless, most of the time, when interest rates rise, so do stocks. Of course, certain sectors have historically outperformed during periods of high Interest rates, such as banks, Industrials, and semiconductors. The bottom line for investors is that while rising rates will favor certain market segments over others, most often rates and stock prices rise together.

1) Impact of Macroeconomic Variables on the performance of stock exchange: a systematic review, November 29, 2019

2) Stock prices, exchange rate and interest rate: evidence beyond symmetry, January 26, 2018

3, 4) Blackrock, Why rising rates won't derail stocks, 2021