On May 22, the US central bank announced that it would begin to lower its bond purchases later this year. Interest rates increased and stocks fell. But that does not mean that rising interest rates are negative for equities.
The common position among equity investors is that the positive stock price development of recent years is largely due to stimuli from, among other things, the US central bank. But what happens when, at some point, the central bank begins to step down the bond purchases that the market has taken for granted for a long time – is it negative for the stock prospects?
Based on US data back from 1965, our analysis shows that cyclically-dependent interest rate increases and the start of a monetary-policy tightening are positive for equities in the vast majority of cases. The challenge for the stock market is when structural changes in interest rates occur as a result of, among other things, a strongly accelerating inflation. However, it is a scenario that is likely to lie somewhat out in the future.
Interest rate increases are not just interest rate increases
Since May, interest rates have risen significantly both in the US and in Europe. The reason has been that the US central bank back in May signaled that if the recovery in the US economy continued, the bank would begin to reduce the massive bond purchases that kept interested rates low for an extended period.
When measuring the effect of rising interest rates on shares, it is necessary to distinguish between two types of interest rate increases. One type is the cyclically-dependent increase, where the marginal change in interest rates is due to an underlying improvement in the economy and hence to longer-term inflation expectations. This type of increase in interest rates takes place as the economic expectations improve and market interest rates increase without the central banks’ interest rates necessarily changing. Examples of this could be periods around the mid-1990s, 2003-2004 and 2009-2011. The opposite is also true in the event of a sharp fall in market rates due to recession expectations, which is a very bad scenario for shares. The cyclical interest rate increases are here defined as the change in the ten-year US government rate over a three-month period.
Structural interest rate changes
The second type of interest rate increase is a more permanent change in interest rates over a longer period. This type has historically been the reason for more structural economic changes. An example of a structural long-term interest rate increase could be the period from 1972 to the early 1980s, where rising interest rates over a whole decade led to P / E contraction and poor equity returns.
Conversely, a long-term structural interest rate decline until the end of the 1990s led to multiple expansion and good equity returns. Since this is a long-term structural shift in the interest rate level, such a change can often only be recorded when it has happened, simply because the interest rate rise or fall runs over a number of years. The duration of structural changes in interest rates is here set as a starting point for three years.
The reason for choosing the ten-year yield point on the government yield curve is due to the fact that this particular interest rate plays a crucial role in determining the long-term return requirement from the shareholders through the Capital Asset Pricing Model (CAPM). Different movements in this point of interest, therefore, have a decisive indirect effect on the required rate of return on equity and thereby on the valuation of public limited companies through the discount factor. When the ten-year yield point changes as a result of a cyclical movement, it is often an expression of movements in the flow. For example, when the market experiences a cyclical interest rate increase – especially a cyclical real interest rate rise – it is often positive for equities, as in this scenario, the economy is improving without the negative effect of sharply rising inflation.
Cyclical interest rate increases result in stock price increases
To investigate the historical correlation between stock price developments given by the US S&P 500 index and cyclical and structural changes in the
ten-year US government rate, regressions have been made with the interest rate changes as the explanatory variable.
In the first part of the analysis, the correlation between cyclical interest rate increases and the development in the S&P 500 index since 1990 is analyzed. Thus, the three-month change in the US ten-year government interest rate is compared with the change in the stock index over the same period. As mentioned earlier, the cyclical interest rate increases in this context were defined as the change in the ten-year US government rate over three months. Major changes in interest rates over this period are historically linked to a change in perception of the fundamental economic variables – either the expectation and the signs of economic growth (rising interest rates) or the deterioration of the economic variables and the expectation of a slowdown or even recession (falling interest rates).
Since 1990, there has been a not statistically significant positive correlation between the change in the US government bond yield and the change in the stock index. In other words, this means that in cyclical interest rate falls, the stock market tends to experience price declines, whereas the stock market has historically reacted positively to cyclical interest rate increases. The background is, among other things, that strong cyclical interest rate falls over a period of three months have historically been the result or the expectation of a sharp slowdown in economic activity and even the expectation of a recession. Conversely, a strong cyclical interest rate increase is the result of or the expectation of increasing economic activity that will increase earnings in the companies that are part of the stock index, which in the long term results in price increases.
Structural interest rate changes have historically been negative for the stock market
The graph at the bottom shows the correlation between more structural interest rate changes measured over three years since 1965. The figure thus illustrates the correlation between the change in the ten-year US government interest rate over three years and the associated equity return over the same period. As can be seen, there is a tendency for a negative correlation between the interest rate change and the equity return. Highly rising interest rates over three years have historically resulted in low or negative equity returns while falling interest rates have resulted in positive equity returns. As the graph just tries to capture the structural shift in interest rates, there is a clear tendency for groupings in the data set.
In the case of a structurally rising interest rate, the periods 1971-1975 and 1977-1981 differ, as there can be seen a relatively clear grouping tendency in connection with interest rate increases here. The beginning of the 1970s was characterized by quite strong interest rate increases from the US central bank immediately following a period of recession in 1970 due to a sharp rise in inflation.
The positive response pattern in the period 1977-1981 was immediately after the second recession in 1974-1975, when economic growth rose quite sharply before, in 1981-1982, the sharp rise in inflation with interest rate increases again. Since structural shifts can vary in duration, regressions of four and five years of interest rate change have also been included in the graph. As shown in the figure, the negative correlation between structural interest rate changes and the stock market is intensified as the window for interest rate changes is extended to four and five years.
Inflation is an important key to understanding the relationship between interest rates and equities.
The trend from the regressions between cyclical and structural shifts in nominal interest rates and the effect on equities was that cyclical interest rate increases were typically positive for equities, while structural interest rate increases were often negative. Inflation is one of the derived effects that determines whether economic developments over time should be slowed by interest rate increases to limit the negative impact of rising inflation on the economy. Such a fight against inflation has historically led to quite substantial structural changes in interest rates, as discussed above (including the early 1970s).
Below is a one-year return on S&P 500 as well as the annual rate of increase in inflation since 1943. It is difficult from the point of view of the points to form an unambiguous relationship, but immediately an annual rate of increase of between 1.5% up to approximately 3.0% historically, to generate the most positive observations on the one-year return on equities. In other words, it seems positive for equities to have positive moderate inflation, as this historically has generated one-year equity returns of between 10-40 percent. In short: Moderate, positive inflation combined with rising interest rates (rising real interest rates) has historically had a positive effect on equity returns.
In the same inflation interval, there are also periods of very strong negative
returns. Among these observations are 2000-2002 and 2008 as the most recent observations. In the period after the IT bubble, the US economy experienced an expectation adjustment, especially in the IT sector. The adjustment also had a moderately negative effect on economic growth, which, despite having kept inflation at a relatively high level through these years. In other words, the falling real interest rate had a negative impact on the stock market during this period.
The reason is that, if the cyclical interest rate increase simultaneously takes place with moderate, stable inflation, the real interest rate return reflects a healthier underlying economy, whose progress causes a shift from secure securities to real assets such as shares. With annual US inflation of around 1.5 percent and a market expectation of a moderate and relatively stable future price trend1) there is thus no indication that the central bank needs to raise interest rates provisionally in order to combat inflation. The reaction to the market interest rate since May must, therefore, be best characterized as being cyclical and must therefore still be expected to have a positive effect on the stock market through an improvement of, among other things, the demand components.
Where are we now?
Since May, the ten-year US government rate has risen by 1.0 percentage point to 2.7 percent. The interest rate increase has been significant and has taken place over a relatively short time interval, which so far must be categorized as being a cyclical interest rate increase. The increase in interest rates has come on the basis of an improvement in the US economy and an expectation that this will continue while the US central bank’s stimulus program is expected to be reduced over the coming quarters. Although the cyclical interest rate increase we have seen so far has been significant, it has not had a negative impact on the US stock market. On the contrary.
For a long time, wealth management has argued that the stock market will in the future be to a greater extent to be drawn from demand-driven earnings growth. Over time, this revenue or demand will come into play as the underlying economic fundamentals improve further, leading to stock price increases and further cyclical interest rate increases.
For this reason, for example, we maintain our positive outlook on equities with a long-term, attractive return potential, and of course, we also maintain our current high allocation to equities. Among the many uncertainties affecting stock markets, the story suggests that cyclical interest rate increases may not be something investors need to worry about.