Inflation, interest rates and discount rates in Australia explained

If you thought prices were rising, you were absolutely right. Australian consumer price inflation came out and it was a whopper. The highest headline inflation number we’ve seen since 2000-01. And back then inflation was high because of the GST. If you ignore that anomaly, it is the highest inflation since 1990.
This hurts in many ways, including in the stock market. The ASX was down on Wednesday, but not all parts of the market are in the red. High inflation makes some types of companies more valuable and other types of company less valuable.
Who gets hurt? The companies who are not that profitable now. Especially ones who are spending money to make money, like gold explorers and early-stage tech companies.
Money now is worth more than later
To understand why, ask the simple question, would you rather a dollar now, or a dollar next year? The smart person will answer: a dollar now. It’s got more buying power now than next year. And if you need a dollar next year just save it up. A dollar now can be easily turned into a dollar next year by just not spending it. The reverse is not true!
Inflation reduces the buying power of a dollar next year, so high inflation means people start to want a dollar now even more than a dollar next year.
How much would you be willing to pay to have a dollar now instead of a dollar next year? If I offer you $1 now and ask you to pay me back $1 next year that’s a great deal and you should take it. You might also be willing to pay back $1.01. After all, things that cost $1 now will cost more than $1.01 next year. Some people might even be willing to pay $1.10.
The price people will pay to swap a dollar now for a dollar later is one of the most important concepts in finance. It is called the discount rate. Some people have high discount rates, some have low, but they change over time, depending on interest rates and inflation.
If you have a high discount rate, you’re willing to pay a lot for a dollar now and you probably have debt (young people and broke people usually have high discount rates).
If you have a low discount rate, you’re willing to accept payment for giving away a dollar now and you probably have money in the bank (old people and rich people usually have lower discount rates).
Basically this is what a loan is – you pay to get a dollar now. The price you pay is the interest rate. People are willing to pay higher interest rates when inflation is high, because their discount rates are rising. (And lenders want higher payments on the money they lend because inflation is eating away at the buying power of that money faster).
It’s all connected. Interest rates, inflation and discount rates move together. In 2022, interest rates are rising, inflation is rising, discount rates are rising. And that affects a lot of things, including the stock market.
Companies that take money now and hopefully reward you handsomely later are no longer so great when discount rates are rising.
If we look at the big companies that have the highest dividend yields on the ASX, we’re looking at companies like BHP, Rio Tinto, These companies pay out big bucks to their shareholders. BHP’s most recent dividend was $2.08 per share, and that’s not the only dividend it will pay this year.
Does BHP have amazing growth prospects? No. China is already building a lot of apartments and roads. The price of iron ore and copper are very high. It’s hard to imagine any of that getting even better. This is a company with a bright present, not necessarily one with an even brighter future. Right now that’s what investors want.
BHP went up today as the market sank. Rio Tinto did the same. While recent fluctuations in the iron ore price are also affecting their stock prices, as the next graph shows, they’ve been outperforming the market for months.
At the other end of the scale we have technology firms who are spending money building things that don’t make money yet. The biggest losers on the stock exchange on Wednesday included Life360. Its website tells you it is “not just an app.”
“We added 71,000 net new subscribers,” said the Life360 CEO, while announcing the company had cashflow of negative $38 million. That’s language that used to work – people used to care about subscriber growth and laugh at losses. Not so much now. Now investors are like Cuba Gooding Jr in the movie Jerry Maguire: they’re shouting “Show me the money!”
Of course, smart investors knew high inflation was happening, so today’s results alone do not reflect the full extent of the whack inflation has delivered to certain parts of the stock market. It has happened over time. One example is Zip.
Zip is a Buy Now Pay Later firm that has made some big losses. In the most recent six months it had revenue of roughly $300 million, and spent around $500 million, creating a loss of approximately $200 million.
There’s a lot of companies like that right now – precisely because low discount rates made such companies popular to invest in. Low discount rates – caused by the low inflation and low interest rates of the last decade – are why people have been so excited about start-ups in the last ten years. These are the companies that now stand in front of the scythe.
Zip’s stock price was down 5 per cent on Wednesday. But that’s nothing compared to how it has gone this year so far. It has fallen from $4.33 to $1.02. Hopeful investors in January have lost three-quarters of what they invested.
The whole NASDAQ index – the US stock market stuffed with young tech firms – is down 20 per cent so far this year as investors who were excited on growth, now want profits.
When Netflix starts showing you ads and/or charging more – which they’ve promised to do after their stock price fell 60 per cent – that is part of the same phenomenon. Netflix is trying desperately to give investors what they want – profit – so it can avoid even bigger price falls.

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