The Impact of Rising Interest Rates on Equity Markets

Stock Market Outlook in a High-Interest-Rate Environment

Financial markets are not limited to the equity and stock markets -- they also include the debt market, fixed income securities, money market, commodity market, foreign exchange market, and many more. Multiple factors influence the returns generated by all these markets. In India, due to a lack of awareness and limited financial inclusion, trading predominantly takes place in the equity markets, while other facets of the financial system remain largely unexplored. Only a small fraction of the population is aware of these other markets. To better understand the interconnected behaviour of each market, we need to examine the movement of interest rates and their impact on businesses, which directly affects stock prices.

To begin with, let us understand:

How Do Interest Rates Work?

Interest rates represent the cost of borrowing that the borrower pays to the lender. Businesses often borrow funds from banks and financial institutions to expand their operations. The Reserve Bank of India (RBI), or any country’s central bank, controls interest rates—that is, the cost of borrowing at which money is lent to the public, corporates, etc. This allows the central bank to control inflation and implement monetary policy to support economic growth.

For example:

The rate at which the RBI lends money to banks is called the Repo Rate. This acts as the base cost of borrowing for banks and, by extension, the broader economy.

Let’s say a bank borrows ?100 from the RBI at a repo rate of 6%, meaning the bank must pay ?6 for every ?100 borrowed. Now, if the RBI increases the repo rate to 7%, the bank will incur an additional cost of ?1, i.e., it will now pay ?7 for every ?100 borrowed. This added cost is eventually passed on to the bank’s customers who borrow money for productive or unproductive purposes. Repo rate hikes are primarily aimed at reducing the excess money supply in the economy to help control inflation.

How Do Equity Markets Function?

Equity markets provide a platform for business organizations to raise large amounts of capital without an obligation to repay the money in the future. Unlike loans, equity does not have a maturity period or fixed interest payments, which makes it more attractive for companies compared to borrowing from banks or institutions. Today, even small and medium enterprises can raise funds by issuing equity in the SME segment of the Indian stock market, making capital generation more accessible to a wider range of businesses.

Connection Between Equity Markets and Interest Rates:

Equity markets are indicators of a nation’s economic growth, while interest rates reflect the cost of borrowing and are used as tools to manage that growth by regulating money supply. The two are deeply interconnected. When interest rates rise, the cost of borrowing increases. This results in lower economic growth, as businesses become more hesitant to borrow and delay expansion plans. Lower output and consumption follow, which decreases disposable income in consumers' hands. Consequently, savings and investments decline, with investors shifting from equities to safer financial instruments.

Higher borrowing costs negatively impact companies’ earnings and profitability, leading to a reduction in their valuations in the capital markets. Investors start preferring safer investments that offer consistent returns over riskier equities. However, rate hikes do not negatively affect all sectors. For instance, the banking sector tends to benefit as rising interest margins improve profitability. HDFC Bank and SBI, for example, saw strong performance during the RBI’s 2022–2023 rate hike cycle. While interest rate hikes may benefit some sectors, they can hurt others. During the same cycle, global rate hikes—especially by the U.S. Federal Reserve adversely impacted IT companies worldwide, narrowing their profit margins and affecting their stock prices.

Impact of Global Rate Hikes on India:

Indian equity markets are not severely affected when the U.S. Federal Reserve announces rate changes, but they are impacted marginally. A recent example occurred in 2022 when the Fed aggressively increased its funds rate to combat inflation in the U.S. As a result, foreign institutional investors (FIIs) withdrew $20 billion over a span of 1.5 years, leading to a sharp depreciation in the rupee and a 5% drop in benchmark indices to adjust for the rising cost of capital due to higher import costs. When the Fed raises rates, global investors tend to pull their funds from other countries and reinvest in the U.S., as the U.S. bond market offers stable returns and the dollar is considered the world’s most stable currency.

Conclusion:

To conclude, interest rate hikes impact certain sectors by increasing their borrowing costs. These sectors tend to experience slower-than-expected growth, while essential sectors like FMCG and Banking may record stronger financial performance. Large-scale investors and institutions often shift their focus from equities to safer, interest-bearing government securities, which offer a hedge against volatility in equity markets. Equity markets are inherently volatile, with price movements often reflecting the psychology of market participants. In contrast, interest rates are foundational to the cost of borrowing and play a critical role in regulating money supply and economic growth. Thus, interest rates significantly influence financial markets, serving as important indicators of a country’s economic direction.

--Team ELPL