Interest rates could still rise painfully more

The gloom on the stock markets has continued. After all, September is statistically the weakest month for the stock market, so this is not so surprising.

A nasty reminder of the technology cold war between the US and China was the Chinese ban on iPhones for government employees. Apple, the world's most valuable publicly traded company, has lost around a couple of hundred billion of its market capitalization, although the sales limitation itself applies to perhaps 500,000 iPhones a year, while in China 45 million iPhones are sold a year. But this is a stark reminder of how even the world's most powerful technology company is not safe.

In this post, we talk about how the economy of Germany, an important export partner for Finland, is showing further weakness. There is also a tentative slowdown in the global economic locomotive in the US, but so far it does not seem sufficient to slow inflation, let alone economic growth. Therefore, we will be talking about the possibility of interest rates going much higher. Central banks tend to go overboard in all directions. And this, of course, is a risk for equities.

The German economy is rattling

Germany, an important export partner for Finland and Europe's largest economy, continues its downward trend. New orders in the country's manufacturing sector fell in July, according to the latest data, and the country's industrial production continues to contract. Germany has been hit by a perfect storm as an economic strategy based on cheap energy from Russia and demand from the rest of the world has run aground.

Business expectations for the future in the country are falling close to the weak sentiment at the start of the war in Ukraine. As companies listed on Nasdaq Helsinki are in many cases dependent on global industrial demand and investments, we should also prepare for a continuation of the weak operating environment for the time being. Another important driver is China, where economic news flow is also notoriously weak.

In this interesting graph, I have drawn a parallel between German business confidence and the development of Nasdaq Helsinki. While the only driver of the Helsinki Stock Exchange is not, of course, German business activity, the two seem to go together like two peas in a pod.

 

Interest rates may rise further

Since interest rates started to rise at the end of 2021, investors have been waiting for a return to lower rates. Interest rates offer an alternative to equities. If you get, say, 4% interest on your money, risky stocks don't taste as good. Therefore, rising interest rates put downward pressure on equity valuations. Similarly, falling interest rates would support the stock market if we simplify things a bit.

Central banks are responsible for keeping inflation under control. For central banks, the policy rate is a way of tightening monetary conditions in the economy. When the price of money, i.e., the interest rate rises, it is no longer worth borrowing for consumption or investment. This cools the economy, which in theory cools inflation.

Currently, the Fed policy rate is above 5%, with core inflation hovering at 4.3%. Often the policy rate has been raised well above inflation. Note how in this graph, where the Fed policy rate and inflation are juxtaposed, how often the policy rate is well above inflation, thanks to the roaring economy.

Despite nearly two years of rising interest rates, the US economy has remained hot. For example, wages are still rising at an annual rate of 5.3% despite the cooling, according to the Atlanta Fed's gauge. This is the same as the peak level of previous economic cycles.

 
The rise in interest rates will not be passed on to the economy immediately. There are at least a few reasons for this. First, one person's interest payments are another person's income. In the US, the debt-laden federal government's interest bill has already ballooned to almost $700 billion and is expected to rise sharply as old bonds mature and are replaced by new bonds at higher interest rates. Investors own about 60% of the federal debt and the federal government pays the rest into the pockets of the Fed or its own institutions. The rising interest costs will thus partly go back into households' pockets. Rising interest rates may even stimulate the economy in this way.

Second, the debts of most households and businesses are locked into fixed low interest rates for years to come. Thus, rising interest rates are not immediately felt in your own interest payments, but instead your own savings in a bank savings account or money market funds start to pay off. 

Financial conditions—i.e., how easily businesses and households can access finance—have also remained supportive of the economy. This graph shows the Bloomberg index of financial conditions in the US, which has again tipped to the looser side.

There are different lengths of interest rates on the market. Short-term interest rates follow the Fed policy rate. For example, the interest rate on a one-year bond is 5.4%. By contrast, longer rates, such as the 10-year bond, which has been dubbed the financial world's gravitational force, are more reflective of investors' perceptions of future inflation and economic growth. In other words, the yield curve has inverted, with longer rates yielding lower returns than shorter ones. Such a position has often heralded a recession.

I read a good comment from Bloomberg editor Edward Harrison that long rates in the US could rise above 5%. If the economy does not go into recession, as more and more people believe, and the Fed is not lowering rates because of embarrassing inflation, there is no reason why long rates, with more risk and waiting, should get a lower rate than short rates. As the Fed's interest rate weapon is slow to bite the economy, interest rates will have to be kept higher for longer.

Fortunately, the impact of rising interest rates on shares can be seen with simple maths (source: me, I only know simple maths). If the risk-free rate (the mentioned the US 10-year rate) were 3% and a historical risk premium of 5% was added (how much extra return is required on equities), the required return on US equities would be 8%. Imagine a listed company whose performance is static from year to year. With an 8% required return, we can pay 12.5x earnings per share to get the required return.

If the US 10-year rate yielded 5%, the required return would be 10%. This would bring the P/E ratio of the stock down to ten.

Of course, the real world is more complicated than that. Rising interest rates are not only a sign of persistent inflation, but also of a strong economy. And a strong economy underpins the performance of listed companies. Analysts are predicting record results for S&P 500 companies in 12 months' time.

But at some point, higher interest rates will bite the economy. The threat of recession is still in the cards. This could be a slippery slope for optimistically priced stocks in the world's largest stock market. A downturn in the world's largest economy would, of course, also hit our home stock market, because the US is, directly or indirectly, an important market for many Finnish companies.

The upside of rising interest rates is that investors do not have to take risks in equities. You don't have to buy NVIDIA, when you can get a return on your cash. In the US, retail investors are already being pampered with 5% interest rates. Even in Finland, interest rates on savings accounts are under upward pressure. Shares are no longer the only option for savings.

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