The impact of interest rates on growth stock returns : European stock market analysis

Abstract

Interest rates are among the most fundamental concepts and financial instruments in the financial world. The effect of interest rates and monetary policies exercised by central banks on the stock market is a widely studied field in finance. Interest rates are found to be one of the main factors that explain the movements of the stock market. Conventional wisdom states that the relationship between stock market returns is negative as interest rates increase, stock prices decrease, and vice versa. However, the relationship and the sensitivity have been found to differ for different stocks and stock portfolios. Growth companies are often associated with high innovation, job creation, and economic development and they are considered to contribute well to every economy. While growth investing tends to underperform compared to value investing, it is still one of the most common investing strategies, where investors invest in growth companies that carry high expectations for future growth and -profits. “Momentum” and diversification may be among the main factors that drive the popularity of growth investing, but still, all professional investors seek to optimize their risk management to their preference within the chosen investment strategy. Recent rate hikes by the European Central Bank in 2022 have ended the lower-bound interest rate period, which started soon after the financial crisis of 2008. Now, as the interest rate levels in Europe and globally may shift back to the long-term average after a decade of lower bound rates, it is reasonable to inspect the academic literature on the impact and significance of interest rates on growth stock returns. This study implements an empirical analysis of the European stock market and examines the effect of interest rate fluctuations specifically for the market price of growth stocks. The analysis shows time variation within the results, indicating that sensitivity between interest rate fluctuations and growth stock returns varies for different periods due to economic cycles, monetary policies, and other economic factors. Careful interpretation of the results indicates that during lower bound interest rates, growth stock returns and interest rate fluctuations have a positive relationship, and they may have a co-movement behaviour to positive or negative economic news and events. The results of this study are assumed to be interesting to professional investors from the perspective of interest rate risk management and asset allocation strategy.