Swedroe: Rising Rate Effects Unclear

June 13, 2018

As the director of research for Buckingham Strategic Wealth and The BAM Alliance, one of the most-asked questions I’ve gotten lately involves the impact of rising interest rates on equity prices, with the conventional wisdom among many seeming to be that increasing rates are bad for stocks.

The specter of rising interest rates aside, it’s not as if investors don’t already have enough to worry about, with U.S. equity valuations at historically very high levels (the Shiller CAPE 10 ratio, as I write this, is above 32), the potential threat of a trade war, the risk of Italy leaving the euro, as well as other geopolitical risks, including North Korea, Iran and Syria.

With a strong economy, investors are becoming even more worried about rising interest rates and the effect they could have on equity (and bond) valuations. So what, if anything, should investors do with their equity portfolios in response to rising rate risk? As always, to answer that question, I’ll turn to academic evidence and financial theory, rather than some guru’s opinions.

Key Dichotomy

Perhaps the most important thing is not to confuse knowledge with value-added information. Let me explain.

In investing, there is a major difference between information and knowledge. Information is a fact, data or an opinion held by someone. Knowledge, on the other hand, is information that is of value.

In this instance, the information is that the Federal Reserve is expected to increase interest rates perhaps two more times in 2018. That leads many investors to conclude they should minimize equity risk, as equities compete with bonds. Thus, rising rates would no longer be supportive of today’s historically high valuations.

Of course, this ignores the lesson the market taught in 2017, as the Fed raised rates three times last year, yet the S&P 500 returned almost 22%. With that in mind, let’s turn to a review of the longer-term evidence on the link between stock prices and bond yields. Thanks to Andrew Berkin, the director of research at Bridgeway Capital Management and the co-author of two of my books, “The Incredible Shrinking Alpha” and “Your Complete Guide to Factor-Based Investing,” for his study, “What Happens to Stocks When Interest Rates Rise?”, which appears in the Summer 2018 issue of The Journal of Investing.

Rising Rates Study   

Berkin begins his analysis of the historical evidence with a review of the theory of the relationship between bond yields and stock returns. He asks: Why might stocks go down when yields rise?

Basic investment theory states that the value of an investment should equal the sum of its discounted future cash flows. Therefore, as interest rates rise, so should the discount rate, which implies that stocks should be worth less. Higher rates also slow the economy, which can dampen earnings and cash flows. Furthermore, higher yields make fixed-income investments more attractive, and equity valuations may suffer.

However, there are also reasons stock returns may be positive in the face of higher yields. Rising rates reflect a robust economy, which should enhance corporate profits and cash flows. In addition, the market already should have priced in expected changes in interest rates and cash flows. Certainly, a rise in bond yields this year would not be an unexpected event.

Berkin concluded: “There are good reasons for both sides of the direction of stocks, and which will win out is hard to say.” The reason is, as Berkin writes, that “equities are influenced by a variety of factors.”

To predict the outcome accurately, an investor would need not only to forecast the future direction of interest rates and their impact on GDP and inflation, but also to forecast accurately how it compares with what other investors already anticipate. That has proven to be an exceptionally difficult task.

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