Does a rising interest rate mean lower stock returns?

Given the interest rate up-cycle, the natural effect is that discount rates used to discount the future cash flows of businesses increase, translating to a correction in stock valuations. As interest rates rise, few investors tend to switch from equity to fixed-income instruments as its relative attractiveness increase.

Interest rate is just one of the factors determining returns of the equity markets. In the past two decades, there have been 3 years (including the current year) where the US 10-year bond yield rose by more than 100 bps but the Nifty 50 index delivered positive returns in all these years (Data as of 27 October 2022).

This is largely because rate hikes do not negatively impact all sectors. Startups reliant on external funding and companies with high leverage are the first to experience the heat of the rising interest rate. On the other hand, financial companies engaged in lending business tend to benefit as increase in interest income from advances tend to be higher than the increase in interest outgo on public deposits. As long as corporates are able to pass on higher input costs in a gradual manner, corporate earnings would be restored over time. In effect, fund managers can position the portfolio in a manner wherein the impact of rising interest rates can be minimised, enabling a reasonable experience for investors.

Earnings Matter over Interest Rate

The primary driver of stock returns over long term is corporate earnings. The declining trend of earnings estimates by analysts have reversed over the past two years. Reported earnings have fared reasonably well compared to estimates for the past many quarters. The current phase in India’s economic cycle, after many years of subdued growth prior to covid, is supportive for corporate earnings. Even if we were to see a temporary decline in markets, triggered by global macros and recession fears, India’s underlying fundamentals point to a scenario wherein the impact of these developments will be relatively moderate. However, one cannot rule out near term volatility due to global factors. Historically, investors tend to react to short term developments which is an erroneous approach for a long-term investor. Past data suggest systematic investment at even average levels has yielded reasonable returns for a long-term investor.

Stay long, continue Systematic Investment Plan (SIP)

We calculated the average of 3-year rolling returns from 2005 till October 2022. Outlier entries (returns>30%) are excluded to portray a realistic picture. If an individual had stayed invested for at least three years, there was a near zero chance of loss in capital even for investment at peak of Nifty.

The average rolling return for investment at (SIP on 1st of every month is considered) since 2005 on a 3-year basis stands at 11.7%, comfortably beating inflation. In the last 17 years, the Indian economy has seen various interest rate cycles. Further, three years is a minimum investment timeframe to invest in equity market. If you follow a disciplined approach and stay invested for the long term, it can prove to be a rewarding experience, irrespective of interest rate or market direction.

Though investing at the trough of the market would show a theoretical high return, investing across cycles (via SIP) would ensure a reasonable return that exceed inflation. Investment at peak prior to the market crash in December 2007 and trough of markets in October 2008 would have generated a compounded annualized return of 8.7% and 14.0%, respectively, till October 2022. A monthly SIP starting from 1 January 2008 till date (duration of 14.8 years, with Nifty delivering negative 51.3% in 2008) has delivered compounded annual return of 12.9% till date. If you have a long-term investment horizon and the objective is to generate returns that beat inflation, SIP in equities emerges as an optimal choice.

George Thomas is the fund manager- equity, Quantum AMC.