Rising interest rates are generally seen as bad news for share markets. However, higher interest rates are usually being imposed to dampen inflation, which is another phenomenon that can negatively impact share prices. Understanding the mechanics that underpin the relationship between interest rates and markets can help investors anticipate how changes may impact their investments. They can then be better prepared to make informed financial decisions. While periods of high inflation and rising interest rates can feel destabilising and create uncertainty, both are part of a normal business cycle and may present investment opportunities.

Are further rate hikes likely?

The Reserve Bank of Australia recently decided to hold the cash rate at 4.35%, following the decision to raise it by 25bps in November. This widely expected move will serve as a welcome reprieve for many Australians at Christmas time, with borrowing costs currently at their highest level since January 2011, in the wake of 13 rate rises since May 2022. 

RBA governor Michelle Bullock noted that while the monthly CPI indicator for October suggested that inflation is showing signs of moderation, there is still vast uncertainty around the broader economic outlook. The monthly CPI indicator came in at 4.9% in the 12 months to October 2023, according to ABS data, which is markedly lower than September’s figure of 5.6%, but still remains much higher than the RBA’s target band of 2% to 3%. While economists are divided on the likelihood of further rate hikes in 2024, many hold the view that rates will remain higher for longer. 

The latest data shows that inflation remains far higher than the RBA’s target band of 2-3%. Image source: RBA

Interest rates vs. stock prices

Rates have been historically low since the 2008 global financial crisis as central banks tried to stimulate consumer spending and growth in its aftermath. In Australia, interest rates have been at rock bottom levels since the Covid pandemic, achieving a record low of 0.10% in November of 2020. Rising rates ever since has meant it costs more for companies to borrow money, whether this be by business loan or selling corporate bonds to bring in cash. For investors, this has meant businesses with higher returns on capital look more attractive, as these can fund their operations from existing cash flows and have less need to take on debt.

The impact of rising interest rates was particularly noticeable over 2022. While other macroeconomic factors also had an influence, the various sectors diverged massively in terms of Australian equities benchmark performance. Over 2022, the S&P/ASX 20 (3.63%), S&P/ASX 50 (1.89%) and S&P/ASX 100 (0.63%) all managed to deliver a positive result. On the other hand, the S&P/ASX Energy Companies index (-22.51%) and the S&P/ASX Small Ordinaries Index (-18.38%) suffered significant declines.

Strategies for investing when interest rates are rising

Rising interest rates tend to weigh on stock valuations as professional investors scrutinise balance sheets. In this environment, they are more likely to favour the low debt-to-equity ratios of large, stable companies over smaller operations that may be exposed to higher borrowing costs or flagging consumer demand as disposable income is eaten up by mortgage rate increases. While the drag on corporate profits and growth potential can have a broad impact on share markets, not all sectors are impacted equally. Short-term and floating-rate bonds should also be considered during a rising rates cycle as they reduce volatility. 

Here are three popular strategies to consider when deciding how to position your portfolio:

1. Invest in inflation-proof stocks

The financial sector is one area where higher interest rates to curb inflation may serve as a tailwind since lenders can potentially earn more on loans. Historically, banks and other financial institutions have outperformed during periods of rising rates as the higher cost of taking out a business loan or servicing a mortgage benefits shareholders. However, to return to our 2022 example of a rising rates environment, not all bank shares profited equally. Indeed, the home sector of ASX 200 banking shares, the S&P/ASX 200 Financials Index fell almost 3% over the 12 months ending 31 December 2022 compared with the broader ASX 200, which tumbled around 5%. The bright spots were Westpac (up 9.4%) and Suncorp (up 8.8%).

2. Invest in cash-rich companies

Generally, sectors relying on discretionary spending levels languish in a rising rates environment relative to sectors producing necessities. This means utilities, energy, consumer goods and food are likely to perform better than auto, durables, retail and apparel sectors. But this only tells part of the story and company-specific metrics are a key component. Specifically, when a central bank signals that fund availability is going to be constrained in the future, having a higher level of cash holdings becomes more beneficial. For investors, this means prioritising companies with relatively strong balance sheets, greater market presence and greater financial stability, which tend to outperform in this environment.

3. Buy bonds

Fixed income is an important part of a well-diversified portfolio and diversified bond holdings are a key part of protecting a portfolio from the impact of rising rates. There is an inverse relationship between bond prices and interest rates, which means that as interest rates rise, bond prices fall (and vice versa). The longer the maturity of the bond, the more it fluctuates in accordance with changes in the interest rate. This means that, in the short term, rising interest rates may negatively affect the value of a bond portfolio. However, over the long run, rising interest rates should increase a bond portfolio’s overall return. This is because money from maturing bonds can be reinvested into new bonds with higher yields.

Inflation and rising interest rates can have a big impact on your investments, and this is one of many factors that should be considered when evaluating your investment strategy. Despite what may seem like tough conditions for investors, there are still plenty of opportunities to earn returns in your portfolio — you may just need to rebalance your portfolio to hedge against inflation. 

To help you evaluate your investing strategy and make informed decisions about your portfolio, you can use Sharesight’s online portfolio tracker. Designed for self-directed investors, Sharesight allows you to automatically track your Selfwealth trades, inclusive of dividends, tax and overall portfolio performance. Sign up for a free Sharesight account to start tracking your investments (and tax) today. 

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