Will Rising Rates Mean a Falling Stock Market?

Hot air balloons over countryside

2018 has seen the emergence of some new trends. Volatility returned as stocks logged their first official correction since early 2016, coming on the back of a year (2017) that never saw a 3% decline – which hadn't occurred since 1995. Economic trends have also shifted - 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.

Perhaps the most notable shift is in interest rates. Ten-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. Historically low interest rates have been a staple of this bull market. Thus, 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. Consider the following perspective: 

  • Rates are higher, but not high – We think interest rates will 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 perhaps 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%. In fact, the Canadian and U.S. 10-year rates averaged 6.2% of the past peaks of the stock market.
  • 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 ultimately endure a similar fate, but this outcome is not imminent, in our view. As economic growth firms, inflation is likely to creep higher, keeping the Bank of Canada and the U.S. Federal Reserve on a path of gradual rate hikes. Going back to the '50s, Fed tightening cycles had an average increase in short-term rates of more than 4%, more than double what we've experienced so far. A recession could emerge before the Fed gets to that average level, but we think there is  more room to raise rates before this expansion ends.

Stock markets have performed well during the initial 3% increase in the Federal Reserve's Fed Funds Rate

MKT-10967-C--chart

Performance data from Morningstar Direct. Past performance is not a guarantee of how the market will perform in the future. Indexes are unmanaged and are not available for direct investment. All returns expressed in local currency and include reinvested dividends.

  • 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/spending. 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, geopolitics 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.

Investment implications of rising rates:

  • Lower valuations, higher focus on earnings - Low rates often support higher stock valuation levels (the price-to-earnings ratio), 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, but with the gradual withdrawal of central bank stimulus and rates still at historically modest levels, we don't think this will happen abruptly. 
  • 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 as the bull market in stocks progresses and bonds have proven to be a reliable ballast for portfolios amid stock market pullbacks. 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.

Important Information:

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.

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.

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