Interest rate sensitivity on full display
Head of Equity Strategy
Summary: Bubbles stocks and many aggressively priced US biotechnology stocks have been the hardest hit segments of the equity market lately. In this equity update, we illustrate this interest rate sensitivity, which is fully explained and predictable by equity valuation theory. We show the dynamics of interest rate sensitivity for aggressively valued technology stocks through concrete examples on cost of capital.
Today we follow up on Tuesday’s note on cost of capital as the last couple of trading days have shown that the interest rate sensitivity is well alive and is showing up exactly where the theory of equity valuations would predict it. As we have said multiple times, the two hardest hit segments in the equity market from rising interest rates are the capital-intensive industries with a high degree of debt financing (utilities, telecommunication, real estate etc.) and the aggressively valued technology companies. It makes sense that highly debt financed companies are impacted as the cost of capital is dominated by cost of debt which has a direct link to the rising interest rates. This is also why our green transformation basket was hit initially by rising interest rates.
Applying classical statistical analysis on the interest rate sensitivity is difficult and due to the low signal-to-noise ratio in financial markets, it is almost impossible to crystalize the interest rate sensitivity in broader equity indices. As we wrote on Tuesday on the back of interest rate and equity market data since 1962, we observe that monthly equity returns are cut in half when interest rates are rising compared to when they fall. In any case, equities still have their drift (positive trend) despite the direction of interest rates and likely also what Fed Chair Powell recently alluded to when he said there is no real link between interest rate changes and equity markets.
One way to illustrate the interest rate sensitivity is to compare the 10-day rolling mean return of S&P 500 vs our bubble stocks basket on different levels of US 10-year yield since 4 August 2020, which is date then long-term US interest rates bottomed out – we have been in a rising interest rate environment ever since. Here is becomes quite clear that as the US 10-year yield moved above 1.2% the return dynamics of S&P 500 and our bubble stocks changed quite dramatically. Unless interest rates continue aggressively higher from here, we believe the equity market and bubble stocks will consolidate and stop the bleeding. If, however, the US 10-year yield march towards 2% in a fast fashion it could cause havoc in the speculative parts of the technology sector.
Why are technology companies hit by rising interest rates?
Another reason why the Fed insists on a low overall impact on equities from rising interest rates, and which has been vindicated lately per our chart above, is due to the concept of equity risk premium. This is the key to understand why bubble stocks have been hit hard by rising interest rates.
The equity risk premium on US equities is currently estimated to be 4.6% by finance professor Aswath Damodaran, which is the leading expert on equity risk premium and equity valuations, which is close to the lowest level since the Great Financial Crisis. The US equity risk premium has been stable over the past 10 years with an average of 5.6% and a standard deviation of 0.7%. This takes us to the next concept of cost of capital which is essentially the weighted average of cost of equity and cost of capital.
Cost of equity is essentially the risk-free rate (US 10-year) plus the equity risk premium expected by investors. The S&P 500 has currently short-term and long-term debt of 1,152 per share which means that the average S&P 500 company has a debt ratio of 23% in the cost of capital equation. Using the yield-to-maturity on US investment grade corporate bonds of 2.35%, we can calculate the cost of capital for S&P 500 as (1.55% + 4.63%) x 77% + 2.35% x 23% = 5.28%. Of this cost of capital the risk-free rate is only a 30% component – a 100 basis point move higher from current levels, assuming constant credit spread and unchanged equity risk premium, would increase cost of capital to 6.28% or a factor of 0.19 increase in the discount rate.
If we look at the bubble stocks, then we are suddenly talking about companies where the equity side is 98% of total cost of capital. What makes it worse is that they are all aggressively valued with implied equity risk premiums in the range -2% to +1%. This means that the risk-free rate suddenly dominates the cost of equity and since the equity weight is close to 98% in many of these names the entire segment is very sensitive to rising interest rates unlike the overall equity market.