Will Rising Rates Mean a Falling Stock Market?

By Craig Fehr June 20, 2018

The first half of the year has seen a return of market volatility and the emergence of new economic trends. Today we'll focus on how these things might impact investors, and what to keep in mind as the second half of 2018 unfolds.

Starting with economic trends: Growth in Canada has slowed after leading the G7 last year, while U.S. conditions are seeing a boost from Washington's new tax reforms. In particular, corporate earnings have accelerated, with expectations for profit growth of nearly 20% for the S&P 500, the strongest in eight years.
When it comes to noteworthy economic news, interest rates are front and center. Although we've seen historically low interest rates throughout this bull market, 10-year rates in Canada and the U.S. reached multi-year highs this year, including rising above 3% in the U.S. for the first time since 2014.

Consequently, the lift in rates has been met with some anxiety in the stock market, reflecting the concern that rising interest rates will bring an end to the expansion. Context is important here, so consider the following perspectives.

We think interest rates will continue to rise, but gradually. It’s important to remember they’re rising from a historically low base. After more than half a decade of short-term rates at or near zero, this recent modest increase has felt more material than a longer-term view would suggest.  Since 1950, there have been no North American recessions that began when 10-year rates were at 3%.

Second, rising rates may eventually spoil the party, but not yet. Economic expansions – and bull markets – do often end at the hands of high interest rates. We think this expansion could endure a similar fate, but this outcome is not imminent, in our view. We think there is more room for the Bank of Canada and the U.S. Federal Reserve to raise rates before this expansion ends.

Third, rates are rising for the right reason. Higher rates have been a response to a potential uptick in inflation, stemming from the healthy labour market's support for wage gains and consumer confidence. Restrictive consumer debt levels and a softening housing market will hold back domestic growth this year, in our view, but the expansion doesn't appear to be exhausted. And, recent data south of the border suggests business investment may be on the upswing. Strong corporate earnings also support a positive outlook for capital investment, putting some gas in the economy’s tank.  Policy risks, geopolitical uncertainties and interest rate worries are likely to spur ongoing bouts of volatility, but sustained economic and earnings growth will, in our view, make pullbacks more temporary versus the onset of a bear market.

It always helps to be prepared for whatever market moves are on the horizon. And, if rates do continue to climb, there are potential implications to be mindful of.

First, low rates often support higher stock valuation levels, given the impact on future profits. As rates rise, the valuation multiple is likely to trend lower. This doesn’t mean the market has to fall, but it raises the importance of earnings growth, producing positive but more moderate equity market returns as we advance. We think rates will eventually rise to a level that would be more challenging for equity market valuations. However, with gradual withdrawal of central bank stimulus and rates still at historically modest levels, we don't think this will happen abruptly.

Second, don't avoid bonds. While rising rates put downward pressure on bond prices, we don’t think investors should abandon fixed-income allocations.  We believe stock market volatility will persist and bonds have proven to be a reliable stabilizer for portfolios amid stock market pullbacks. For example, during the last five official corrections, stocks declined by an average of 14%, while bonds delivered an average return of 6.5%.1 To reduce the impact of rising rates on portfolios, we recommend keeping a little more in cash and short-term fixed-income investments, and reducing exposure to long-term bonds.

Talk with your advisor about what impact these economic variables might have on your investing strategy.

Important Information:

1Corrections measured by a 10% or greater decline in the S&P 500 index. Bond performance represented by the average return of the Barclays U.S. Aggregate Bond Index and the FTSE TMX Canada Universe Bond Index in Canadian dollars. Investment Indexes are unmanaged and cannot be invested in directly.

Past performance is not a guarantee of what will happen in the future. Bond investments are subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value.

Equity investments carry risk, including the loss of principal. There are special risks inherent in international investing, including currency, withholding taxes and high levels of taxation, political, social and economic risks.

This information is for educational and illustrative purposes only and should not be interpreted as specific investment advice. Investors should make investment decisions based on their unique investment objectives and financial situation.

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