Interest Rates and Stock Market Performance

Interest rates are oftentimes referred to as the “costs of money.” As such, prevailing interest rates will directly influence the aggregate economy. The stock market, of course, is a direct reflection of long-term economic performance. All investors must appreciate the interplay between economic cycles, interest rates, and the stock market to manage money strategically.

Corporate Finance

Corporations issue credit and sell shares of stock to investors to raise capital. Creditors make loans to corporations and collect interest payments upon bonds and money market securities. Creditor claims are senior to shareholders, which means that assets must be liquidated to pay bondholders first, in the event of bankruptcy.  

Shares of common stock represent equity, or ownership stakes within the corporation. Share prices generally track corporate profits, which may appreciate towards infinity. Here, low interest rates and cheap financing should improve profitability. Alternatively, higher interest rates weaken earnings and devalue future cash flows. Financial stocks are especially sensitive to interest rate movements.

Competing Investments

Equities do compete directly against bank deposits and fixed income securities for investment dollars. Expect capital flows to shift out of equities and into fixed income through a high interest rate environment. Here, relative safety at a reasonable rate of return may trump the uncertainties of risky assets.

The Federal Reserve, however, slashed rates to zero in response to both the 2008 housing crash and COVID-19 pandemic. Now, the real rate of return on cash is negative, after subtracting out inflation. Conservative savers react by jamming cash into stocks and driving the market through all-time highs.   

Investment Strategy

Intelligent investors build diversified portfolios to mitigate interest rate risks. Energy and materials stocks will perform well amid inflationary environments, while debt-laden utilities, banks, and insurers will falter when rates shift higher. Consumer staples stocks in food and healthcare will remain stable.