Personal Wealth Management / Market Analysis

Why Higher for Longer Rates Haven’t Stopped Stocks

Our research shows rates at present levels aren’t toxic for stocks.

Higher for longer interest rates were supposed to be toxic for stocks, according to commentators we follow. But since March 2020, UK and other rates (short and long) globally have climbed with world stocks.[i] In our view, this illustrates warnings over rates killing stocks is again overblown.

Exhibit 1: Global Stocks Undeterred by Rising Rates Since 2020


Source: FactSet, as of 2/7/2024. MSCI World price index in pounds and 3-month and 10-year Gilt yields, 1/7/2006 – 1/7/2024. A bear market is a typically prolonged, fundamentally driven decline exceeding -20%.

The widespread thinking we observe that stocks abhor high rates stems from a textbook way to value securities: using current interest rates to discount future corporate fundamentals like sales or profits.[ii] The higher the rate, the lower those fundamentals’ present value—at least in theory. Hence, rising rates supposedly hurt growth-orientated stocks like Tech more because, theoretically, much of their earnings or sales are further in the future.[iii] When interest rates rise, proponents we follow say the present value of those distant profits shrinks faster—or so the thinking goes.

Problem is, we find this doesn’t regularly work in practice—not for stocks generally nor Tech specifically. To illustrate this, let us explore the theory using America’s S&P 500, which we use for its long history and abundant Tech exposure.[iv]

Exhibits 2 and 3 show the index versus 3-month and 10-year US Treasury yields, split for easier visualisation into the generally rising rate period through the early 1980s and after. There are plenty of times besides the current cycle when stocks rose alongside rates—like in every bull market (period of generally rising stocks) from 1954 to 1983.

Exhibit 2: Rates Don’t Dictate Stocks’ Direction (1954 – 1983)


Source: FactSet, as of 2/7/2024. S&P 500 price index and 3-month and 10-year US Treasury yields, 30/6/1954 – 30/6/1983. A bear market is a typically prolonged, fundamentally driven decline exceeding -20%. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.

Or, for example, see rising rates during 2015 – 2019 and 2004 – 2006—they didn’t forestall the bull markets in Exhibit 3. Now, 2009 – 2019’s long bull market—and 2020 – 2021’s brief one—featured low rates overall, but they didn’t cause stocks’ liftoff, in our view. And the wiggles and waggles higher in those stretches don’t regularly coincide with market weakness. Regardless, pre-2008, before the low-rate era began, we think few would have batted an eye over stocks and rates moving upwards together given the regular occurrence.

Exhibit 3: Rates Don’t Dictate Stocks’ Direction (1983 – 2024)


Source: FactSet, as of 2/7/2024. S&P 500 price index and 3-month and 10-year US Treasury yields, 1/7/1983 – 1/7/2024. A bear market is a typically prolonged, fundamentally driven decline exceeding -20%. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.

As for higher rates being especially bad for growth-orientated stocks, Exhibit 4 shows S&P 500 Tech sector relative returns against the fed-funds target rate—the US Federal Reserve’s (Fed’s) main policy rate. Again in previous cycles, purportedly tighter monetary policy didn’t stop Tech outperforming in 2015 – 2019 and 1994 – 1995. Ostensibly looser policy in the early 2000s did nothing to stop Tech’s deflation. The mid-2000s’ rate hikes may seem to have stymied Tech, but we think this is mostly the aftermath of the Tech bubble—investors fought the last war throughout that value-orientated bull market.[v] Regardless, Exhibit 4 shows there is no consistency: Rising rates weren’t auto bearish for Tech, nor were falling rates bullish.

Exhibit 4: Or Growth Stocks’—Like Tech’s—Relative Returns


Source: FactSet, as of 2/7/2024. S&P 500 Information Technology and S&P 500 total returns and US fed-funds target rate, 1/7/1989 – 1/7/2024. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.

That isn’t to say rates have no effect on stocks. In our view, aggressive rate hikes contributed to 2022’s bear market—alongside soaring inflation (economywide price increases), Russia’s Ukraine invasion, sanctions and energy price spikes, all amidst global supply chain chaos. In our view, those hikes started with surprise, as officials talked up transitory price increases and rates staying low beforehand. We think the combination weighed on sentiment, helping drive 2022’s mild bear market, and then warnings went too far, setting up positive surprise.

Rising rates can also disproportionately affect sectors reliant on them, like Real Estate, which is down -4.3% year-to-date, the only sector with negative returns.[vi] But for Tech? We find generally cash-rich balance sheets in the sector make it more immune to rates, not less, and increasingly, large Tech is quite profitable in the here and now—not just the far future.

This brings us to the main reason why we think high and/or rising rates aren’t anything to fear. Our research shows stocks don’t move on them, but on surprise. In late 2022 and early 2023, markets had pre-priced widespread alarm over rising rates’ impacts (along with a bevy of other warnings), in our view. Many headlines we read went so far as to warn of a 1970s redux. We think the alarm went too far, irrationally depressing expectations—and making positive surprise easier to attain. As Exhibit 5 shows, rates never soared into the mid-teens like then, sitting instead at historically normal levels—which we find isn’t terrible. Nothing here looks all that unusual to us when you take a broader look.

Exhibit 5: US Rates Around Their Historical Average


Source: FactSet, as of 2/7/2024. 3-month and 10-year US Treasury yields, 1/7/1954 – 1/7/2024.

Moreover, to say what may seem profane presently: There are some benefits from higher rates. One, savers are rewarded more from interest income to the extent banks pass this through. Your emergency cash isn’t paying zero, which helps discourage people from seeking creative solutions to zero interest, in our experience.

Now, some commentators we follow also suggest high rates on cash and bonds are so attractive they will lure people out of stocks. But we don’t think they are in competition. For long-term investors, stocks trounce cash (and bond) returns—and are far better at staying ahead of inflation.[vii] The reality, in our view, is this simply means cash reserves aren’t return-free. Regaining some purchasing power after inflation’s spike is fine, but for many, we doubt that is enough to reach their long-term financial objectives.

Two, the higher bar for borrowers helps weed out speculative endeavours less likely to turn a profit down the line, according to our analysis. To the degree this directs capital to more profitable projects, we find it lowers the likelihood of excesses building in the economy, extending expansion. Without excesses, in our view, there isn’t much reason for recession (extended economic contraction)—its main purpose is to wring them out.

Lastly, we think there is another ancillary benefit from higher rates: It likely cuts down on monetary policy experimentation. Based on our observation, the low-rate era had many monetary policy institutions around the world get, shall we say, creative: from quantitative easing and negative interest rates to capped long-term interest rates and complicated programs to boost bank liquidity. The results are questionable at best and, we have found, usually counterproductive.

When monetary policy institutions are routinely undertaking large-scale extraordinary measures and unconventional policies because they find their typical toolkits lacking, the void of certainty that can leave may itself be destabilising. Higher rates don’t guarantee a return to normal monetary policy operations—and less confusion—but we think they do make it more likely. And, in our view, boring central banking is better.

Overall, for investors, we see the same rate fears recycled ad nauseum for two years lingering today. But we find reality continues proving better than expected—which is why stocks keep ploughing ahead.

 


[i] Source: FactSet, as of 2/7/2024. Statement based on MSCI World price index in pounds and 3-month and 10-year Gilt, US Treasury, German Bund and Italian BTP yields, 23/3/2020 – 1/7/2024.

[ii] “Discounted Cash Flow (DCF) Explained With Formula and Examples,” Jason Fernando, Investopedia, 6/11/2023.

[iii] Growth-orientated companies are those that tend to reinvest profits into their core business and typically trade at higher prices compared to corporate earnings and other similar measures.

[iv] Source: FactSet, as for 2/7/2024. Statement based on S&P 500 Tech sector’s 33% weight in the index.

[v] Value-orientated companies are those that return more cash to shareholders and trade at relatively low prices compared to underlying business measures, like sales or earnings.

[vi] Source: FactSet, as of 2/7/2024. S&P 500 Real Estate total return, 31/12/2023 – 1/7/2024.

[vii] Source: FactSet, as of 2/7/2024. Statement based on S&P 500 and 3-month and 10-year US Treasury total returns, 4/1/1954 – 1/7/2024. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.

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