Investors have been unsettled by the possibility of more rises in US interest rates. Whether they are right to be so is, however, a tricky question.
Elementary economics says they shouldn’t be. The Fed has forewarned us of such rises: last month it said there would be two of them this year. This prospect should therefore be already discounted by share prices so these shouldn’t move if the Fed’s prediction is right.
History, however, tells us that things are not so simple and that in fact rate rises can actually be good for equities. Since 1992 there has been a strong positive correlation between annual changes in the Fed funds rate and in the S&P 500, of 0.44. Rising rates in 1994-96, 1997-98, 1999-00, 2004-06 and 2016-17 were all accompanied by rises in share prices.
There’s a simple reason for this. The same economic growth that causes the Fed to raise rates also raises corporate earnings and investors’ appetite for risk, which boosts share prices: there has for years been a strong correlation between US industrial production growth and annual equity returns. This can happen even though the Fed signals rises in advance, thanks to what Harvard University’s Matthew Rabin calls projection bias. People tend to project their current tastes into the future and fail to anticipate that they’ll change. This means that even if they foresee economic growth they’ll not anticipate that this will increase their appetite for risk. The upshot will be that shares will rise even if economic growth is expected.
If all this sounds optimistic, that’s because it is. The correlation between economic growth and the stock market broke down last year: the economy did well but the market did not. This warns us that rising rates might hurt shares. There are three ways in which this might happen.
One danger arises from the possibility that the rise in prices since 2010 has been due in part to a 'reach for yield': investors bought shares not because prospects for the economy were great but simply out of despair at the pathetic returns on cash. To the extent that this has been the case higher rates might reverse this process, causing equities to fall even if they don’t much harm the US economy.
It’s hard to say how great this danger is. High equity valuations are consistent with there having been a reach for yield: even after its recent fall the cyclically-adjusted price/earnings ratio on the S&P 500 is well above its average. But this is inconclusive as there might be other reasons for high valuations such as low bond yields and the likelihood that greater monopoly power means that profits are more sustainable now than they were in the past.
Experimental evidence is also inconclusive. While one study has found evidence in laboratory conditions of a reach for yield, another has found that this only happens when interest rates are negative.
In a sense, though, the empirical evidence is irrelevant. What matters isn’t just the truth, or even investors’ beliefs. What also matters is what investors believe about others’ beliefs. If enough traders fear that others will fear a reversal of the reach for yield, rising rates will cause shares to fall.
History warns us of a second danger. The positive correlation between the Fed funds rate and share prices is a modern phenomenon. In the 1970s and 1980s it was more common for shares to fall as rates rose. This was because in its efforts to cut inflation the Fed would sometimes raise rates so much as to cause recession.
You might think that with wage inflation rising only slowly despite the lowest official unemployment rate for 50 years, this is not a danger. But again, the facts aren’t everything. Those of us whose formative years were in the 1970s and 1980s when inflation was high and volatile are prone to worry too much about it; as Stefan Nagel and Ulrike Malmendier have shown, our economic opinions are shaped not just by current facts but by experience in our youth. If enough of us do so, fears that the Fed will have to raise rates a lot will hurt shares.
A third danger is that investors will worry – or worry that others will worry – that the Fed will overestimate the strength of the economy and so raise rates too much. The Fed has tried to assuage these fears by saying that rates will be set in part on “readings on financial and international developments” – which is a way of saying they’ll not raise them if shares fall. The very fact that prices fell so much late last year, however, suggests markets aren’t so sure about this. Herein lies a difference with the past: whereas markets had confidence in Greenspan and Bernanke not to disturb stock markets unduly, they have less trust in Jay Powell.
In this sense, perhaps nervousness about rising rates reflects a wider societal development – declining trust. An unhealthy society contributes to an unhealthy stock market.