Executive summary
Market commentators often claim that higher interest rates will lead to lower equity prices. In our view, many of these claims are overly simplistic and inconsistent with both empirical evidence and the fundamental drivers of equity valuations. While certain segments of the market are sensitive to higher interest rates, it is entirely plausible that interest rates and equity markets can rise in tandem as monetary policy settings return to neutral levels.
Monetary policy settings are tightening
After a prolonged period of extreme monetary stimulus dating back to the GFC, monetary conditions are set to tighten and interest rates will rise. The key unknown is the pace and degree of tightening over the coming years.
With the start of the monetary tightening cycle, we can expect market commentary to focus on the impact higher interest rates will have on the economy and asset prices. There have already been several alarmist calls such as one from Deutsche Bank last week who nominated the “Great Central Bank Unwind” as candidate “Number One” for the next global financial crisis.
Much commentary in relation to equity markets will focus on the impact of higher interest rates on stock valuations. The common argument is that 10-year government bond rates are used in equity valuation models, therefore, a rise in interest rates will translate into lower valuations.
But how concerned should we be about rising interest rates in relation to equity markets?
One post-GFC example of equity markets responding negatively to a tightening of monetary policy occurred in 2013 in what is now known as the ‘Taper Tantrum'. As can be seen from the chart below, the speech by US Fed Reserve Chair Ben Bernanke’s on May 22 announcing that they would be gradually reducing the amount of money being fed into the financial system triggered an almost 10% fall in the S&P500 index.
What is most interesting from the above graph, however, is that the US equity market recovered from the correction within months and went on to record significant gains over the following year.
In contrast to the 2013 taper tantrum, last week’s decision by the Federal Reserve to commence unwinding their post-GFC stimulus program has received a much more muted response from the markets.
Does this demonstrate complacency on the part of equity markets or is there a rational basis to suggest that equity prices and interest rates can rise in tandem?
Interest Rates and Equity Valuations
The historical evidence demonstrates that equity valuations expand in the early stages of the monetary policy tightening cycle, as demonstrated in the table from Pinebridge Investments below.
Forward P/E and 10 Year Rates at different levels of inflation (1950-2016)
(Source: Schiller, Pinebridge Investments)
| Annualised CPI (Inflation) | Ave Annualised CPI | Ave 10 Year Rate | Ave Real 10 Year Rate | Ave Forward P/E |
|---|---|---|---|---|
| 0-1% | 0.6% | 2.6% | 2.0% | 13.0 |
| 1-2% | 1.4% | 3.6% | 2.1% | 19.6 |
| 2-3% | 2.5% | 5.0% | 2.5% | 24.4 |
| 3-4% | 3.4% | 6.8% | 3.4% | 14.4 |
| 4-5% | 4.4% | 7.3% | 2.9% | 14.6 |
| 5-6% | 5.2% | 7.9% | 2.7% | 15.6 |
| 6-8% | 6.9% | 8.9% | 2.0% | 10.2 |
| 8-10% | 8.8% | 8.4% | -0.4% | 9.5 |
| 10-12% | 11.1% | 10.2% | -0.9% | 7.4 |
The above data shows that equity P/E multiples have historically expanded until the point that inflation reaches 3%. Equity valuations have only started to fall when inflation rises above 3% and monetary policy settings become contractionary.
The reason that equity values expand as interest rates rise can be explained by conventional asset pricing theory. In particular, the discounted cash flow model that is widely used to value shares uses estimates of future free cash flows and cost of capital in the calculation. Improving economic prospects increase estimates of future cash flows and decrease the risk premium applied to calculating the cost of capital (investors are willing to accept a lower return on capital given the reduced company risk). This results in increased equity valuations despite higher interest rates.
It is entirely plausible, therefore, that with the global economy facing its strongest outlook since the GFC, equity valuations can continue to rise even as governments start to tighten monetary policy.
Higher Risk Sectors
We should not expect all sectors to respond the same way to rising interest rates. Recent history has show that the so-called ‘bond-proxies’ could suffer as investors revise the long-term interest rate assumptions that have supported their valuations.
Our JJT Advisory portfolio strategies have had minimal or no exposure to sectors such as infrastructure and utilities due to their high valuations based on lower for longer interest rate assumptions. As interest rates rise, we will wait for an opportunity to buy at more attractive prices and add a more defensive component to our portfolios ahead of the next turn in the cycle.
We must always be alert to the risk that ‘this time is different’ as high levels of government debt present a key risk for this monetary tightening cycle. While Australia’s government debt is lower than most other developed economies, our highly leveraged households present a risk to property prices and consumer spending if interest rates rise substantially. It is likely, therefore, that the global and Australian economies will be more sensitive to interest rate rises but the view of regulators is that monetary policy settings can be tightened without de-railing economic growth.
DISCLAIMER
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.