Will stubbornly high inflation and rising interest rates lead to lower stock prices and a bear market this year?
It’s a question on every investor’s mind after Thursday’s U.S. inflation report showed consumer prices jumping 7.5 per cent in January, the biggest year-on-year increase since February, 1982 – sending the benchmark 10-year U.S. government bond yield to 2 per cent for the first time this decade.
As is usually the case in real-life situations, the answer to the question is not clear-cut – it all depends.
It is true that interest-rate increases affect the discount rate at which future cash flows are discounted to the present. The higher the discount rate, the lower current values. But value is not only determined by the discount rate. It is the interaction of expected cash flows with interest rates that determines value. If future cash flows are expected to increase faster than the increase in interest rates, then fundamental value will increase. Future cash flows are affected by the state of the economy and economic growth expectations.
One statistic analysts have used to gauge the health of the economy is the slope of the yield curve, namely the difference between the 10-year and the one- or two-year Treasury bond yields. A positively sloped yield curve – when long-term debt interest rates are higher than shorter-term debt rates – signifies optimism about the economy going forward. A negatively sloped yield – also known as an inverted yield curve, when longer-term debt instruments have lower yields than shorter-term debt – signifies pessimism about the economy. Historically, on average, a negatively sloped yield curve has been a precursor of an economic slowdown, and even recession.
To help us understand the effect of rising interest rates on the stock market, it is useful to examine historical evidence of the effect of a rising interest rate environment on stock prices. Evidence shows that stocks have risen, on average, by 9 per cent per annum during Fed tightening cycles since the 1950s. As the accompanying table shows, sourced from Lorne Steinberg Wealth Management, there have been 12 tightening cycles by the Fed between 1954 and 2018. On average, stock markets have risen in 11 out of the 12 episodes. It is only in the 1972-74 period that the stock market declined. Averages, however, can disguise the real culprit that could lead to a stock market correction.
To shed light to this question, I examined the annual stock market performance of the S&P 500, as opposed to the average return over whole time periods shown in the table, not only in a rising interest rate environment but also when the slope of the yield curve turned negative. This may help us determine whether this tightening cycle will have an average effect on stock prices or something more sinister.
What seems clear is while it is true that the stock market has risen in most tightening Fed cycles, the devil is in the details.
On a yearly basis, the stock market performance was adversely affected by rising interest rates, but mostly when the yield curve was negatively sloped.
For example, in the 1967-69 rising interest rate cycle, the S&P 500 rose over all, but in 1969, the stock market fell by 8.2 per cent because not only rates rose (one-year Treasuries rose from 5.69 per cent to 7.12 per cent), but at the same time the yield curve became negatively sloped (by minus 45 basis points), which was not the case in the prior years in this time interval.
There are 100 basis points in a percentage point.
In 1972-74, the overall market declined because in 1973 and 1974, the slope of the yield curve turned negative (by minus 47 basis points and minus 64 basis points, respectively) when one-year rates rose from 4.95 per cent in 1972 to 7.32 per cent in 1973, and to 8.2 per cent in 1974, and the S&P 500 index went into a sharp fall in 1973 and 1974.
In 1977-81 the S&P 500 rose over the whole cycle of rising interest rates, but in 1981 the market declined by 4.7 per cent, as again the yield curve turned negative (by minus 88 basis points) in the middle of a rising interest rate environment.
So, what may be the effect of the current Fed tightening phase on stock prices? In my opinion, gradually rising interest rates may not be a threat to the stock market as long as the yield curve continues to be positively sloped.
Currently, growth in corporate profits is expected to decline in coming quarters. At the same time, not only are interest rates rising, but also the yield curve has started to flatten out. For example, the 10-year Treasury minus the two-year bond yield was 160 basis points at the end of 2020 but has now fallen to 52.2 basis points – not negatively sloped yet but given the expected aggressive tightening by the Fed, a negatively sloped yield curve is not out of the realm of possibilities within the next few months.
While the slope of the yield curve does not flash red yet, it is getting there, and this will be the culprit leading to a possible stock market correction, not just the interest-rate increases per se.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, University of Western Ontario.
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George Athanassakos