by Peter Jones, CFA
Vice President of Research
Global markets sold off sharply on Wednesday and Thursday as investors continued to wrestle with a diverse set of risks. First, Fed Chairman Powell’s comments last week on the strength of the U.S. economy and the path of interest rate hikes spooked the bond market, leading to a significant jump in interest rates with the 10-year U.S. Treasury moving to levels last seen in 2011. In addition, China-U.S. trade tensions have shown no signs of abating while a contentious U.S. election season quickly approaches. This week’s market action was undeniably painful, but we want to reiterate that pullbacks are very common and more often than not are just that: pullbacks.
Conventional wisdom is that higher interest rates are a negative for equity prices. The supporting logic is that when interest rates rise, to keep the spread between earnings yields and bond yields unchanged, equity prices must fall. Secondly, higher yields in the bond market create more competition for capital. However, historical data challenges this logic, as it is not unusual for equities to rise with interest rates. This counter-intuitive relationship can be explained by breaking down the causes of change in interest rates. Interest rates can be broken down into two primary components: inflation and growth. The growth component, or the “real” rate is the nominal interest rate less expected inflation. For example, if Treasury yields are 3 percent and expected inflation is 2 percent then real yields are 1 percent. By decomposing the move in interest rates last week, it is clear that the rise was due to an increase in the real rate, or growth component, rather than an increase in inflation, as seen in the chart below.
Source: Bernstein
A rise in growth expectations is unequivocally positive for equities. On the other hand, a bounce in rates due to increasing inflation would merit concern regarding the economic outlook as increasing inflation would suggest a faster moving Fed and thus a more proximate end to the business cycle. While inflation is certainly trending upward, it is gradual and the current level around 2 percent is not enough to cause the Fed to speed its pace. Although rising interest rates are not necessarily bad for equity prices, rapid increases are almost always associated with temporary declines in the stock market as investors digest a new level of rates (see January/February 2018 in the chart above). However, as we found earlier this year and in the “Taper Tantrum” of 2013, the sell-offs are often short-lived.
Midterm Jitters
Along with the rapid rise in rates, investors are grappling with the upcoming midterm election. Because markets do not like uncertainty, midterm elections are often associated with equity market weakness leading into the vote, only to rally through year-end, regardless of the election’s outcome. In fact, the market has finished higher at year-end than it was on election day in 15 of the 17 midterm elections since 1950. While we are constantly evaluating market conditions and do not intend to minimize such sharp declines, our positive view of the global economy and outlook for corporate earnings is unchanged. We believe the rapid move in interest rates along with the typical trading pattern during midterm election season represents a pause and not a change in the business cycle.
Making Money the Right Way
With the S&P 500 declining around 5 percent this week, the P/E multiple has dropped to 16x earnings. The last time the market traded at 16x was the day before the 2016 election. Since the election, the S&P has increased more than 30 percent. In other words, investors have generated strong returns solely from rising corporate earnings with zero contribution coming from more expensive valuation.
Week in Review and Our Takeaways:
The velocity of the rise in rates, not the absolute level, contributed significantly to the sharp decline in equity prices
Markets are often weak going into midterm elections, only to rebound into year-end
Our positive view of the global economy and corporate earnings is unchanged