After many years of double-digit returns, equity investors have become too complacent about market conditions and have clearly underestimated the potential re-pricing implication for equity markets due to a change in monetary conditions. Even though the Fed sent a clear signal at the December FOMC meeting about how serious it was in fighting rising inflation, equity markets did not react until recently this year.
Why are stock returns so sensitive to rising interest rates?
The interest-rate sensitivity is very much the reflection of the stock-valuation process. Let's consider an example by reviewing Apple financials data. From the table one can see that the fundamental financial performance of Apple was astonishing: the Return on Invested Capital (ROIC) over the past 3 years averaged 35% and the EPS almost doubled in only 2 years. On the back of this financial performance, which was accompanied by strong share price gains, the implied cost of capital of Apple declined from 7.5% to 3.5%:
2018 | 2019 | 2020 | 2021 | |
ROIC | 22.8% | 24.7% | 28.1% | 46.1% |
CFO | 77.4 | 69.3 | 80.6 | 104 |
Capex | 12.4 | 10.4 | 7.3 | 11 |
Div | 13.7 | 14.1 | 14 | 14.4 |
FCFF | 51.3 | 44.8 | 59.3 | 78.6 |
EPS | 2.97 | 2.97 | 3.26 | 5.6 |
Price | 39.4 | 73.4 | 132.69 | 177 |
Implied WACC | 7.5% | 4.4% | 4.2% | 3.5% |
Quelle: Zürcher Kantonalbank, Bloomberg
The decline in implied WACC however, cannot be fully explained by the strong fundamental performance. Part of the decline in the implied WACC can be alternatively explained by the benign monetary environment supported by declining interest rates (see chart) which fueled equity valuations. From a bottom-up perspective, it is interesting to note that, Apple’s Net-Debt position is actually negative – so essentially the company is debt free – and a decline in interest rates does not provide any real financial benefit to the company, except for an improving stock-valuation.