Is the prospect of rising interest rates battering ASX shares?

What’s behind the slump in the ASX share market? We take a closer look.

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Key points

  • Both the ASX and global share markets have had a tough few months
  • Many are blaming this on inflation and the prospect of rising interest rates
  • But why would higher rates affect ASX shares?

As many ASX investors would know by now, the S&P/ASX 200 Index (ASX: XJO) has been in a bit of a funk for a few months now. Friday in particular saw the ASX 200 shed a nasty 2.27% to finish the trading day at 7,175.8 points. That leaves the ASX 200 below where it was 6 months ago, and at its lowest point since June last year. Ouch.

Over in the United States, markets haven’t been quite as gloomy. But even so, the flagship S&P 500 Index is now down around 6.5% from its last peak. Many investors have blamed the prospect of inflation, and the higher interest rates that come with it, for the slump in global markets that we’ve seen.

Indeed, the 40-year high inflation reportedly hit earlier this month in the US aligns rather well with the share market slump we have seen across the US and Australian markets since then.

But why is this the case? Wouldn’t the debt-destroying powers of inflation be good for markets?

Why do inflation and higher interest rates spook investors?

Well, not exactly. Sure, inflation does normally mean that both corporate and government debt can be ‘inflated away’. But it’s what normally walks hand-in-hand with inflation that could be spooking markets. That would be higher interest rates.

As the great Warren Buffett once said, interest rates are like financial gravity, pulling everything down to earth. Over the past few years, interest rates around the globe have been at virtually zero. This was a deliberate consequence of central bank intervention to assist the global economy in dealing with the COVID-19 pandemic. Lower rates typically result in cheaper loans, helping to give consumers a spending boost.

But as rates start rising, so too does the cost of borrowing money for every participant of the economy. That includes consumers, businesses, and governments.

If rates were to rise, so too would the cost of a business wanting to borrow money to expand its operations. And that goes for homeowners too. If the Reserve Bank of Australia (RBA) were to raise our own cash rate from the current 0.15% to say 1% or even 2% over the next couple of years, it would mean anyone with a home loan would see their mortgage repayments increase substantially.

So in an inflationary environment, businesses would have to watch their own borrowing costs rise, as well as the purchasing power of many of their consumers fall. All while inflation is driving up the cost of production and labour. So you can see why investors might be spooked by the prospects of inflation and higher rates today.

That is possibly the reason why we have seen both the ASX and the global share market go through some pretty nasty volatility over the past few months. But only time will tell how the macro-economic environment will treat shares in 2022.

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