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What I Care About This Week | 2021 June 21

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by Franklin J. Parker, CFA

The Summary

The Details & Charts of the Week

Interest rates have been a constant news item for, well, years. Along with that conversation is the inevitable discussion of their affect on equities. All else equal, it is true that higher interest rates should lower equity valuations (P/E ratios, or how many dollars an investor is willing to pay for $1 in corporate earnings). That said, it is not always true that higher interest rates yield lower equity prices.

At any rate, I have spent some time looking at both the theoretical change in equity valuations, and, most recently, some time looking at how equity prices move in relation to interest rate moves. In this week’s discussion, I thought we should look at the latter.

Our first look it the obvious one: how do large cap US company prices move with interest rates. Looking at the quarter-over-quarter difference in the 10-year US Treasury yield and the change in S&P 500 prices since 1990, we see that there tends to be a positive relationship: as interest rates move higher, so do S&P 500 prices.

What should be immediately clear is that, while there is a slight positive correlation, we cannot infer that higher rates cause prices to move higher. Indeed, the math would suggest the opposite should be true. It is therefore much more likely that they are both influenced by the same third force: economic growth. As the economy begins to grow, both rates and stock prices tend to move higher, and the inverse is also true.

The good news here is that economic growth often overwhelms the negative force of higher rates in stock prices.

Of course, time period matters. While the chart above is for the 30-year period spanning 1990 to today, the chart below is the 30-year period from 1960 through 1989. As you can see, the relationship, while much looser, was negative. As interest rates went up, equity prices tended to go down. 1960 to 1990 was a period characterized by intense inflation and generally stagnant economic growth, and this could very well be a third and fourth force acting on both interest rates and stock prices, creating an opposite relationship to the one from 1990 to today.

Small cap value stocks have a similar relationship with interest rates, though the correlation is a bit stronger. As rates move higher, so do prices. Again, I take this as a signal that economic growth is a more important factor than higher interest rates, though interest rates do seem to exert some influence.

A sector-by-sector breakdown yields varying degrees of the same effects, with a few exceptions. Rather than walk through each relationships, let’s look at a couple of exceptions.

Since 1990, there has been a loose negative relationship between price changes in the Utilities sector and changes in interest rates. This makes some sense as utilities are a defensive sector, and they also tend to be heavily indebted. When the economy slows down and interest rates fall, Utilities may not fall as often as the broader market because investors sell other sectors to buy Utilities (although Utilities have had some rough quarters when interest rates have fallen!). Also, as interest rates move higher, the cost to service their debts goes up. These two effects could be why this relationship is both negative and weak.

Also of note is the behavior of the Real Estate sector. Real Estate, interestingly, tends to react less to the direction of rates and more to the extremity of the move. As rates move significantly—either up or down—we tend to see a negative reaction in publicly-traded real estate prices. We see this in the chart below—positive price changes cluster around no changes in rates, while negative moves tend to cluster at the left and right of the chart.

Here are my take-aways from this look at interest rates and equity prices:

In the end, investors should be concerned with interest rates and their effects on stock prices, but it should not be the only consideration. It is also not true to say that higher interest rates are absolutely bad for stock prices—it very often depends on why rates move higher. As always, risk control and a firm understanding of the factors working on your investment portfolio are key.

In this context, it is my view that 2021 is likely to be a good year for equities. The Fed is very likely to continue printing money for the remainder of the year, and economic growth—the most critical factor for equity investors—is projected to be very strong.

Not to mention, rates seem unable to move meaningfully higher, anyway.

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