All the news this week has been about stellar earnings from technology giants and the record highs in the US stock market.
Of course, part of the reason for the massive bull run in US stocks over the past 12 years or so has been ultra-low interest rates.
Set by the US Federal Reserve, interest rates basically allow for banks to benchmark their lending rates against it.
Zero rates forever?
Lower rates basically means better lending conditions and, hence, more money in the system. I could get into the technicals of quantitative easing (QE) but that could take a while.
Instead, what does it mean for stocks? Well, overall it’s been recognised “growth” stocks do well in this environment given lending rates are low and investors are buying into the future cash flows (discounted back to the present) of these firms.
But with all the headlines in the financial media about the possibility of rising interest rates causing a crash – which are admittedly sensationalist and aimed at scaring people – it’s worth asking what could benefit.
Rising rates not always bad
Despite everyone equating rising interest rates with a market crash, you have to remember that, historically, periods of rising rates have also coincided with strong-performing stock markets.
In a scenario where the Federal Reserve does raise interest rates, one of the first beneficiaries will be banks. That’s because they make money by lending to businesses/individuals at a slightly higher interest rate than what they pay depositors for their funds.
This is called net interest income (NII). For example, DBS Group Holdings Ltd (SGX: D05), Singapore’s largest bank, derived over 60% of its total revenue from NII alone in 2020.
Bigger spreads
When interest rates rise, it then allows banks to charge higher rates to borrowers of capital. Of course, they’re under no obligation to pay higher rates to their depositors.
Similarly, insurance companies also benefit from rising interest rates. That’s because they hold a lot of “safe” debt such as fixed-income investments. Constantly having to invest into low-yielding assets can eat away at their returns.
Essentially, higher rates will allow insurers to put their policy holders’ money to work in higher-yielding investments to ensure they can meet future liabilities.
Hedging rising rates
For investors everywhere, holding back from investing because of the “fear” of rising interest rates isn’t a valid reason not to put money to work.
But if you are concerned about the impact of interest rates on the stock market, selecting solid banks and insurance companies could be one way of benefitting from a rising interest rate environment.
Although, at this point that seems a long way off.
Disclaimer: ProsperUs Head of Content Tim Phillips owns shares in DBS Group Holdings Ltd.
