Over the past year, interest rates have lifted from practically zero to nearly 5%. This rapid and unprecedented change has a large impact on the economy by affecting the cost to borrow money for things like mortgages, small business loans, and much more. In addition, this interest rate change has an impact on stock prices due to its effect on the price investors will pay for future cash flows. There are many misconceptions about interest rates, inflation, and the stock market. In the next few paragraphs, I will explain how these factors impact inflation, the economy, and most importantly your money.
What do interest rates represent?
In the US interest rates are not only determined by the open market but also by the federal reserve, which can be thought of as America’s bank. They lower interest rates to stimulate the economy and raise interest rates to slow it down. When the economy is really strong and demand for goods causes inflation to rise, interest rates rise in an effort to slow the economy and, hopefully, slow inflation. Therefore, interest rates correlate with the market’s expectation for inflation in the future. Another way to think of this is inflation causes interest rates to rise because investors want their purchasing power to remain the same or increase over time and inflation decreases purchasing power. If inflation is 8% in a year, $100 is only worth $92 at the end of the year. Investors will want their return to at least keep up with inflation, if not outpace it.
How does that affect stock prices?
The thing one must remember about the stock market is that it always looks forward. Investors are constantly asking themselves “how much return on investment can a company give me in the future”. When interest rates are low, investors can assume inflation will be low.
This in turn gives more value to future profits that a company will produce. For example, if inflation stays constant at 0%, a dollar today can buy the same amount as a dollar in 10 years so people are just as happy to take a dollar today as tomorrow. However, with inflation much higher a dollar in 10 years may only be able to buy what 50 cents does today. This means that companies with a lot of profits in the future are worth less during times of inflation and interest rates rising. During these times, market participants want profits now, not later. This makes them even more likely to invest in stocks that give a dividend or fixed return of principal to shareholders. This is because they would rather get a return of $1 today than a return of $2 down the road.
How does this affect your investments?
Inflation and interest rates are not a deterrent to stock market returns. Infact during times of high inflation the stock market overall gave the same returns as periods of low inflation. Periods of rapidly changing interest rates do, however, have a negative impact on market returns.
The figure below shows the US 10yr bond yield (blue) and the S&P500 stock market return (green) is a great example of this. The times of steep stock market decline in 2008-2011 the 10 year yield actually decreased very rapidly. Currently the 10yr yield is increasing rapidly, but the stock market is still going down. This can be summed up simply as investors disliking a rapid change in interest rates, rather than the direction of the change.
How do you outlast the volatility? The key is diversification, if you are only invested in stock growing fast and burning cash, your portfolio will suffer during times like these. If you’re only invested in dividend-paying slow growers, your portfolio will suffer during zero-interest rate environments like what we’ve experienced for the past decade. The S&P500 is very well diversified with hundreds of companies from every sector of the economy, this makes it resilient during unstable periods like the ones were in. Some companies are focused on returning capital to shareholders as fast as possible, others are poised for long-term growth.
Where will rates and the market go from here?
This, of course, is the million dollar question. Typically the market goes down before recessions and starts moving back up during the midst of a recession. This can be seen by looking at previous recessions shown in the figure below (areas in grey are recessions). The 2008 recession is a great example of this forward-looking behavior as the market dropped 10-15% before the recession arrived, and then rallied nearly 20% before the recession ended.
However, this time may be a bit different. Although there is a looming recession because of the rapid increase of interest rates, the economy is still showing strength in certain areas, particularly the job market. This could create a buffer for the federal reserve to continue the rate hike process for longer. This change in expectations could cause the market to suffer further losses in the short term. If you have questions about the market, interest rates, or your portfolio reach out to RogueAdvisors today.
