By Steven K. LewisBy Steven K. Lewis
The short answer is better than many would expect, but it depends on the regime and other events happening at the time.
Where does the fear of rates originate? Aside from the more restrictive financing costs for businesses and consumers, rising rates and/or changing Fed policy can provide a shorter-term jolt to risk assets, largely due to the impact of higher discount rates pulling down the modeled fair values for income-producing assets. In the past decade, the mere removal of extremely accommodative policies, in an effort to get back to some sort of normal (conditions not requiring emergency measures), signified a form of ‘tightening’.
For the most part, central banks and markets elevate interest rates in response to stronger economic growth and/or inflation—each of which needs to be cooled from overheated levels. As stronger economic growth has historically coincided with positive corporate earnings growth, decent equity returns in these environments isn’t that surprising. Inflation is another matter. Beyond a certain level, sustained high inflation can be perceived as more of a headwind. This is not only due to higher interest rates that are assumed to accompany inflation, and lower fair valuations due to present value of money effects, but also the tangible effects of rising costs of wages and goods inputs, which lower corporate profits. As long as the effects of growth outweigh the negatives of higher costs, positive stock results make sense.
However, as the business cycle matures, and economic growth begins to wane, an economy can become more sensitive to inflation and rate effects. This raises another fear about rising rates—in that a central bank will make a policy error and hike too much, pushing the economy into recession. On the positive side, such slowing can prompt central banks to pause rate hikes and/or begin a reversal if this slide starts to occur (and they act accordingly). Recessions have tended to be far worse for earnings growth (and equity prices) than any rising rates (which occur during stronger economies). This data will no doubt be closely watched by the Fed this year, as central banks tend to avoid tightening into a weakening environment. Still-elevated inflation remains the wildcard, something the Fed feels compelled to react to the longer it persists from merely ‘transitory’ status.
Rising interest rates and/or a tightening Fed haven’t necessarily meant doom and gloom for the stock market. Keep in mind, though, that all returns are regime-dependent, with different underlying growth rates, base interest rates, and inflation. (Note that Fed movements prior to the last few decades were much less transparent than they are today; at times before 1979, target rates weren’t always announced. Markets seem to have become more skittish in recent years in keeping with the high level of communication about rate movements.)
Steven Lewis is the owner of the Holly Springs group Lewis & Associates Capital Advisors.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
