The global experience of high inflation and economic volatility has resulted in drastic actions by central banking authorities. Following over a decade of interest rates hovering under 1% in the US, UK and the European Union (EU), investors have suddenly been confronted by successive rate hikes over a short period of time. By Marios Chailis – CMO, The Libertex Group.
Interest rates are one of the most important factors that affect the performance of the stock market. They influence the cost of borrowing, the profitability of businesses, the valuation of assets, and the expectations of investors.
Global economists are coming to the conclusion that the global interest rate hike could be coming to an end. With the US Fed Reserve and the Bank of England deciding to put interest rates at hold at their last respective meetings, it seems as though inflationary pressures are easing. In one respect, this brings about a degree of market relief. The market has adjusted to higher interest rates and it seems to finally be having the desired impact through a drop in inflation.
Does the putting of interest rates on hold signify the beginning of a reverse trend whereby rates will slowly be cut? For the immediate future, this is unlikely to be the case. While things have settled, there is no indication that inflation has been effectively quelled. There are too many uncertainties to contend with, particularly in Europe.
Simply put, retail investors in Europe need to accept the realities of trading in a high interest rate environment, understanding how higher borrowing costs are likely to impact the value and trading of securities.
The impact of interest rates on European trading
Generally speaking, high interest rates tend to have a negative impact on the stock market, as they make borrowing more expensive, reduce profitability and earnings, lower valuations and future cash flows, increase opportunity cost and inflation expectations, and appreciate the exchange rate.
Within this context, the European stock market has performed remarkably well when compared to other financial markets like the US. In the 24 months leading to April 2023, European stocks gained a total of 13.8%. This is in comparison to the S&P, which only managed a 2.8% gain during the same period. If we were to monitor the performance of both markets over the last decade, the US would come out on top. Nonetheless, this two year period is relevant given it takes into account the interest rate hike cycle. The reason for this stark divide can be attributed to the profile of the companies that list on the exchange.
The US has successfully established itself as a leading destination for tech firms seeking to go public. The tech industry is booming, though the pace and scale of the boom has brought a new set of challenges, particularly when it comes to accurate valuations and the companies that have not yet posted consistent revenue growth. High interest rates can impact these businesses who don’t normally have significant excess capital. Profits are typically reinvested and financing may be required.
If the US is known as the beacon for growth stocks, then Europe is seen by investors as a hub for value stocks and companies that are stable and less risky. During the interest rate hike, investors have been turning to Europe to take advantage of value stocks, or company securities that are considered to be underpriced. This explains why the European stock market has outperformed the US amidst the increase in interest rates.
What does the future hold?
Higher interest rates have signaled confidence in the strength of the European economy and its ability to withstand external shocks, such as the war in Ukraine and the global slowdown. They have also supported the euro currency, which boosted the competitiveness of European exporters and their stock prices.
However, there have also been other effects. The rate hike has reduced the attractiveness of stocks relative to bonds and other fixed-income assets, as they increased the opportunity cost of holding stocks and reduced their present value. To a certain extent, it has also dampened consumer spending and business investment, which has a flow on effect on corporate earnings and stock prices.
The coming months will be an important time for retail investors in Europe. Should interest rates remain on hold, it is likely that we will see a degree of stability return. Importantly, the future performance of the European stock market will be determined by events in the US. An interest rate hike in the US could enhance the attractiveness of the European stock market, whereas an interest rate hike in Europe could see more investors gravitating to the US.
The European Central Bank expects the Euro area economy to grow by 1% in 2024, with inflation falling from 5.8% to 2.8%. Should this occur, it is then up to the European Central Bank to determine whether interest rates need to be cut.
A final point to note is on IPOs. Part of the challenge with any stock market is ensuring that companies continue to list and trade on the exchange. This is something Europe is currently struggling with. Only 34 companies went public in Europe during the first six months of 2023, which is the lowest number recorded since 2009. Interest rates do play a role here – the high cost of borrowing can result in companies delaying plans to go public until there is greater certainty. Should listings, and the subsequent opportunities, drop, it is likely to dampen investor sentiment towards European stocks.
For now, it seems as though investors and financial institutions are treading carefully, watching how events unfold not only in Europe but the US and further abroad. There is as much of a reason to be optimistic about the future of the European stock market as there is to be cautious. For now, this will be determined by interest rates, inflation and how geopolitical events unfold.