If you’re looking to invest in the stock market probably you have come across the term growth stocks. If not don’t worry we will cover a very in-depth article on Growth Stocks in our next blog post. As of now we will give brief explanation on what exactly are “growth stocks”. These are stocks of companies which are predicted to grow more quickly than a typical business. Think of innovative tech firms, healthcare disruptors, or clean energy companies etc. that reinvest their profits to fuel future growth instead of paying dividends.
Why do the investors love or prefer to invest in growth stocks? Answer is a simple one : they have the potential to earn good long-term yields and can create a huge fortune for you. However, there’s a caveat that their performance is dependent on one major aspect: “Interest Rate”. Of course there are many other factors which influence the profitability of growth stocks, but here we are just sticking to “Rate of Interest”.
Why interest rates are important for Growth Stocks ?
Interest rates, which are often set by central banks such as The Reserve Bank of India or the Federal Reserve, play a significant role in determining the financial markets. As interest rates rise the cost of credit and loans become more costly. This can affect consumer spending as well as business investment that directly affects the Companies growth.
Furthermore is that higher interest rates make future earnings less attractive when compared to today’s prices. Since growth stocks are rated according to the anticipated future earnings and rising rates could cause a decrease in their value.
On the other hand, low interest rates are a good thing for companies that are growing. They reduce the cost of borrowing and can encourage investment, which makes these companies and their rising stock prices more appealing.
What are interest rate hikes?
Interest rate hike is nothing but deliberate rise in the benchmark interest rate by the central bank of a country, such like the Federal Reserve (U.S.), Reserve Bank of India (RBI) or the European Central Bank (ECB). These rates are the base for all kinds of lending within an economy including auto and home loans, to business credit as well as savings rates.
When central banks increase rates of interest, they’re basically increasing the cost of borrowing money. However they’re encouraging individuals to save more because the yields on fixed income instruments such as deposits and bonds become more appealing.
Who Controls the Interest Rate ?
As we have stated earlier , rate of interest is regulated by central banks, who make use of them as a potent instrument to ensure the stability of the economy. In case of USA the Federal Reserve sets the federal funds rate which affects the cost of borrowing across all financial systems. In the same way the RBI is the one that regulates the repo rate in India.
The decisions are taken by the committees [ officially appointed ] based on important economic indicators like unemployment, inflation, and GDP growth.
Generally why Are Interest Rates Increased ?
There are two primary reasons why central banks increase interest rates:
To control inflation : Hope you know about the term “Inflation”. if not we will cover in our next blog post. As of now we will stick to topic, if we deviate the length of the topic may increase. if inflation rises too fast, cost of products and services to go up at the same pace. In such cases Central banks raise rates in order to reduce expenditure and reduce the economic heat. This can help bring inflation back to levels that are manageable.
To prevent the economy from overheating : In times of rapid growth, spending and borrowing too much can result in the formation financial instability. Rate hikes serve as “brake” or “comma” encouraging more cautious financial behavior.
Read : Investing in High growth Stocks using DCA
Characteristics of Growth stocks
Generally Investors look for Growth stocks as their main goal is longer term capital appreciation instead of immediate income. They are the ones that have an impressive potential for growth faster than the market as a whole.
Let’s take a closer look at what defines a growth stock:
Potentially High Earnings, but Low Present Profits
One of the most distinctive characteristics that distinguish growth stock is its futuristic nature. The companies might not earn huge profits right now however they invest heavily in areas such as marketing, product development, and talent acquisition in order to spur the long-term growth.
Although this can mean little or no dividends but it also indicates it is focused on growing its business, which can result in substantial growth in the future. We can the growth only if the growth trajectory stays in the right direction.
Dependence on Future Cash Flows
Contrary to value stocks, which depend in solid financial fundamentals and earnings, Growth stocks are priced based on expectations. Investors are enticed by the prospect of greater earnings in the future, which means that these companies are prone to fluctuations in the economic environment or interest rates.
If interest rates increase the present value of future earnings decreases, leading to greater volatility in growth stock valuations. This is why understanding macroeconomic trends is vital for investors who invest in this area.
Common Sectors Where we can see growth stocks :
Growth stocks usually come from the most cutting-edge or rapidly-changing industries, including:
a) Technology (e.g. cloud computing, AI, cybersecurity)
b) Biotech and healthcare (e.g. new drugs, health technology)
c) Renewable Energy (e.g. electric vehicles batteries, solar energy and solar)
d) E-commerce platforms and Digital Lifestyle Products
These industries are prone to grow quickly, adapt to changes quickly, and often rewrite consumer behavior. So we can except “growth stocks” in these sectors generally.
How Interest Rates Influence Stock Prices ?
A very significant relationship is between “ Interest rate” & “Stock prices” in the world of finance, it’s usually an inverted one. In simple terms when interest rates are upwards, stock prices tend to decrease. If rates drop, stock prices generally climb. It is as simple as that but what is the reason for this? Lets see the main reason behind inverse relation of “Interest rate” & “stock price”.
Borrowing Becomes Expensive :
If central banks increase rates of interest, it is more expensive for businesses to take out loans. It means that companies may put off expansion plans, cut expenditure, or have to pay more expensive debt servicing costs. In the end, profits may suffer which could lead to a correction in share price of the company.
Less Consumer Spending
The higher interest rates not only affect businesses; they also affect consumers on a daily basis. With EMIs, loans, and credit cards getting more costly, consumers are more inclined to spend less. The lower spending of consumers directly impacts the earnings and revenue of many businesses, particularly those in retail or travel as well as real estate..
Slower Economic Growth :
To reduce inflation and stop the economy from getting too hot, interest rate is used as a vital instrument to balance the economy. But, this can also lead to slow economic growth overall. A slowing economy can result in lower corporate profits across different sectors which makes stocks less appealing to investors.
Attractive Alternatives to Stocks
If share prices are at their lowest, they are usually go to option to earn short term gains or long term gains . However, If central Bank raises the Interest rates, bonds, fixed savings accounts, and deposits begin to offer higher yields with less risk. Generally Investors prefer high moderate returns with low risk . This change in preference of investors could result in cash moving out of the market which causes prices to drop.
Some Sectors May Benefit from Interest rate Hike :
Some stocks are not affected to the increase in interest rates. For instance, banks and financial institutions typically benefit since they are able to offer higher rates of interest on loans which improves their profits and margins.
Summary : Hope we have given clear and updated information on “impact of interest rate hike on growth stocks and it share price”. If you guys have any suggestion regarding the content on “Interest rate hike”, please do let us know the comments section.
