Exorcising misconceptions on interest rate impact on stocks

The financial media’s obsession with the assumption that rising interest rates and inflation are bad for stocks is remarkable—remarkable for being so flat-out wrong.

And flat-out illogical. Rising rates and moderate inflation naturally benefit stocks because they reflect economic growth that usually helps corporate earnings and pushes up share prices.

But this economic reality hasn’t eased the current paranoia surrounding any transitory, miniscule uptick. Any increases are viewed as being on a see-saw, with equity returns on the opposite end. If rates rise, goes the logic, equity returns will probably go down. Never mind that stocks have historically done quite well in months following interest-rate increases, and that most stocks do pretty well amid moderate inflation.

But talking heads and columnists habitually obsess over any wisp of potential for interest rates or inflation to rise. They burn many hours of airtime and countless electrons online fussing over the slightest upward blip, stirring investor fears that equities might plunge, with foreboding on a level close to medieval fear of satanic forces. From the way they act when the yield on the 10-year Treasury bond goes up a couple tenths of one percent, you’d think someone’s head were rotating 360 degrees from demonic possession.

Picking up on this cue, some investors sell stocks, sometimes missing out on near-term gains. You could say the devil makes them do it—devilishly uninformed motivation, that is. Over the longer term, the impact of this behavioral investing on the market is muted by real factors affecting actual value, but these investors have misguidedly damaged their portfolios nonetheless.

Those possessed by these demons need the kind of exorcism that only a clear look at market history can bring. This might lead to some much-needed investor epiphanies about the actual effects of interest rates and inflation on equities.

Some pertinent points:

Research by Strategas looked at seven periods of rising interest rates over the last 30 years. The average annual return for the S&P 500 in ensuing 12-month periods was 20%. The sectors with the highest annual returns were financials (27.5%), technology (26.5%) and health care 23.6%. Further, one well-known researcher looked at this question 150 years back, examining periods of stock market performance one, five and 10 years out from interest-rate increases. He found no discernible impact on returns when adjusted for inflation and dividends. So, the idea that interest rate increases, as reflected in bond yield rises, negatively affects equities has no basis in historical fact; it’s a myth kept alive by repetition.

Normal inflation isn’t bad for equities. Contrary to popular belief, stocks can actually benefit from it, particularly in industries where earnings and revenues tend to rise with inflation-driven price increases. According to an analysis performed by the U.S. Bank Asset Management Group, over the past 30 years, U.S. stocks in a variety of sectors have tended to rise amid moderate inflation.

Historical data show that an ideal annual inflation rate for many stocks is about 3%-- just a bit higher than the 2.6% posted by the U.S. Department of Labor for the 12 months ended March, 2021. (This is quite low historically, and some recent monthly inflation estimates are even lower.) Though a little inflation is not at all bad for the market overall, larger companies tend to be more sensitive to it than smaller companies.

Rampant inflation can pummel equities. People who were around in the 1970s can remember the market damage that occurred when the annual inflation rocketed from 6.22% in 1973 to a whopping 13.3% in 1979. To witness all the hair-pulling these days from slight upticks in inflation (and, notably, no emotional relief from recent monthly downticks), you’d think we were all wearing bell-bottomed pants.

If there’s no evidence that rising interest rates hurt stocks, why do so many people think they do?

For one thing, there’s the notion that P/E ratios are inversely related to interest rates — that these ratios are higher when rates are low and vice-versa. Yet market history clearly shows this isn’t the case.

Then there’s the competing-assets argument: that when rates rise, this makes bonds more attractive relative to stocks because bond yields go up. But given the superior long-term returns of the stock market versus those of bonds, this argument has always been weak. And it has become ludicrous now that bond yields are scraping rock-bottom during a galloping bull stock market. Portfolio diversification has traditionally been a reason to buy bonds, but a growing correlation between stocks and bonds is chipping away at this allure.

Also, many stock valuations are based on or heavily influenced by analysts’ use of the capital asset pricing model—a formula that uses interest rate data to discount future equity earnings. Yet, this valuation method is theoretical rather than market- based. It assumes that cash flows can be accurately projected far into the future, but they can’t. Yet the CAPM nonetheless influences many analysts’ buy-sell-hold ratings and has a significantly impact on prices of growth stocks, including large tech companies.

Regarding inflation, the current contagion of inflation is being fueled by changes in the way the money supply is measured and a limited understanding of what makes the dollar inflate.

Rising inflation is often laid at the doorstep of a growing money supply. Inflation hawks routinely inveigh against the Treasury’s printing more money because they believe money supply is already way too high and that this alone causes inflation. The money supply has substantially increased, but not so much from printing money as from the Federal Reserve’s move this year to reclassify savings deposits as transaction accounts, which caused a retroactive tripling of the money supply.

Moreover, increases money supply alone doesn’t cause inflation. Another key element is velocity of money: the rate at which a dollar is used to buy stuff. And velocity has been declining since 1997, and fell like a rock during the pandemic.

Those worried about interest rates and inflation and their impact on equity performance would do well to examine market history and relax, rather than twitching with every little uptick—or, worse yet, selling stocks in reaction.

David Sheaff Gilreath, a certified financial planner, is a 40-year veteran of the financial service industry. He established Sheaff Brock Investment Advisors LLC, a portfolio management company based in Indianapolis, with partner Ron Brock in 2001. The firm manages over $1 billion in assets nationwide.