Interest Rates is the answer.

If the economy is a car, the money supply is the fuel keeping it running smoothly. Interest rates act as the gearbox, controlling the speed and direction of the vehicle by adjusting lending rates.

As the gearbox ensures that the engine operates at the right pace, interest rates regulate borrowing and spending to maintain economic stability. While investing in the stock market, interest rates are one of the most crucial indicators.

Changes in interest rates usually affect corporate earnings and borrowing costs. It impacts the stock’s valuation, pricing, and risk premium. And investors will only be willing to invest in stocks if they offer higher returns or risk premiums over the risk-free rate.

The risk premium is the extra return an investor can expect from stocks. Historically, the risk premium has been around 5%. So, suppose the interest rate offered by Treasury Bills (risk-free rate) is 6%. In this case, the investor expects a return of 11% from stocks.

As per the above calculations, when the risk-free rates increase, expected returns from equity increase and vice-versa.

Interest rates are likely to fall in the near future. So, how does it impact the stock market?

Ideally, RBI cuts the repo rate amid economic slowdown to boost financial activity. Investors and economists believe that when interest rates are low, it promotes growth as it likely boosts personal and corporate borrowing. As a result, this leads to greater profits and economic growth.

We witness a rise in spending trends with reduced interest rates. Easy and cheap loans often help people achieve their dreams. On the other hand, with an increased ability to finance working capital needs, acquisitions, and the ability to do capex at a cheaper rate, the earning potential of corporates stands to ascend.

As a result, we see higher stock prices. To look at these things from a perspective, let us study how stock markets performed in a lower interest rate scenario for the next three months, six months, and one year. Moreover, we will also try to analyse which sector did well.

As you can see in the above table, the fall in interest rates has proved to be positive for the stock market. Nifty 50 delivered positive double-digit returns in the period of 1 year after the RBI announced its final rate cut.

On the sectoral front, we have calculated 3-month, 6-month, and 1-year returns post-final rate cut by RBI and listed the top 5 sectors by performance.

Interestingly, the Banks, Energy, FMCG, IT, and Consumer Durables sectors have always been the top 5 performers in the lower interest rate scenario. FMCG and the Banking sector have been in the top 3 for all three instances.

Hence, keeping an eye on interest rates while you invest in the stock market is crucial. However, just looking at interest rates in isolation would be a foolish thing to do. And gauging its actual impact on the stock market is complex.

Hence, investors should consider other economic parameters in sync with changes in interest rates to get the most out of it.

So, are you ready to ride on the lower interest rate journey? Let us know in the comments section.

Happy Investing!