Effect of hike in interest rates on equity valuation

Interest rates are like gravity. The less you depreciate them, the higher the asset prices. The most direct impact of lower interest rates comes through a fall in the cost of borrowings for corporates. It also increases demand by reducing costs for consumers. The combination of monetary and fiscal bazooka as the pandemic ravaged the global economy, spurred global investment markets. The equity markets witnessed several expansions in a big way. But interest rates alone don’t explain the spectacular expansion in valuation multiples. For example, in the US, the S&P 500 Index Earnings Per Share (EPS) has risen from the pre-pandemic level of $152 currently to $192, a 26% increase. It is likely to rise further to $222 in the next 12 months. During the disruption and subsequent recovery due to the pandemic, the S&P 500 index would have seen its earnings rise by nearly 50%. For a sustained pace of earnings growth, if interest borrowing costs decline by 100 bps, equity valuations rise by a similar or higher magnitude. It depends on the type of companies that make up the index. For high growth companies, multiple expansions may be overkill. In India, the 3-year corporate bond yield jumped from a peak of 9% in October 2018 to a low of 4.5% in December 2020 and is now at 5.7%. Nifty has moved above Trailing Twelve Month (TTM) EPS 488 Oct 18 to . In 744 now an increase of 52%. The Nifty PE ratio, which stood at 20 on 18 October, went up to a high of 36 in early 2021 and is now back at 23. The 4.5% drop in bond yields resulted in a major expansion of the PE multiple. The Nifty PE multiple has expanded by 300 basis points even with the rebound in interest rates. So to put it simply, every 100 bps fall in interest rates led to an average expansion of 150 bps for the income multiplier in India. Adjusted for earnings growth and an increase in corporate bond yields of 120 bps, the valuation multiplier for the shares contracted by about 250 to 300 basis points. All else remaining equal, higher rates lead to de-rating of income multiples. So the most important question is whether rates can go up or not. RBI chose to remain liberal and pro-growth. But there are two risks: one arising from a rate hike by the US Fed and the other from the risk of increased imported inflation through higher oil prices. For now, prospects look evenly balanced or slightly in favor of RBI’s expectations. But one thing is clear. When interest rates rise, equity de-rates in valuation. The opposite is also true.