How big a problem are rising interest rates for equities? One piece of common-sense theory says: not much. Sadly, though, such common sense is wrong – perhaps more so in the US than UK.
This theory is that the equity premium (the difference between returns on equities and returns on safe assets such as cash or bonds) is independent of the level of risk-free rates. If this is the case, then higher yields on cash or bonds should mean higher expected returns on equities too.
This isn’t a wholly good thing. One way in which expected returns on equities can rise as interest rates rise is if their prices fall to a level at which they are cheap enough to rise thereafter. Once we are at a higher level of rates, though, equity returns should be higher. The journey to higher rates might be uncomfortable, but the destination is pleasant.
Sadly, however, this theory is only half-true. And it’s the bad part that’s true.
Rising rates have been associated with worse returns. Since 1986 there has been a small but statistically significant negative correlation between monthly changes in three-month rates and monthly total returns on the All-Share index. Months in which rates rise tend to see poor equity returns.
High rates, however, do not lead to high returns. Since 1986 there has been no correlation between the level of three-month rates at the end of a month and equity returns the following month. Nor has there been a correlation between equity returns relative to cash and the level of interest rates. This is true whether or not we control for the dividend yield (which does predict returns) and whether we look at the whole post-1986 period or just the 1986-2009 period, when rates were above 0.5 per cent.
History, then, is clear. While rising rates tend to be slightly bad for equities, high interest rates do not lead to higher returns.
I suspect there’s a reason for this. It’s because low rates are ambiguous for equities.
On the one hand, they are a symptom of a weak economy. And you’d expect equities to do badly under such conditions because of earnings disappointments and a lack of appetite for risk.
On the other hand, though, low rates are a sign that the economy faces big risks, which are also risks to equities. Investors should, in principle, be rewarded for taking on such risks.
On average, these two mechanisms have cancelled out.
One thing corroborates this – that the dividend yield on the All-Share index has not changed much since the 1990s even though real interest rates have fallen massively. This is consistent with falling bond yields being a sign of lower growth expectations, which should justify lower equity returns – a fact which offsets the tendency for increased risk to require higher returns.
Herein, however, lies a difference between the UK and US. David Blitz at Robeco Quantitative Investments has shown that in the US higher interest rates lead to lower equity returns: in the UK, by contrast, there’s just no link.
One possible explanation for this difference comes from Princeton University’s Atif Mian and colleagues. They show that low and falling interest rates are great for superstar companies because a lower cost of capital enables them to expand faster than others. And it is these companies that have driven up the overall US market. Since January 2009 (when the Fed funds rate was cut to nearly zero) just four stocks – Tesla (US:TSLA), Amazon (US:AMZN), Apple (US:AAPL) and Alphabet (US:GOOGL) – have added $6.7trn (£5.2trn) to the market capitalisation of the S&P 500. Which means that these four alone have contributed over one-fifth of the rise in the S&P in this period.
The UK market, by contrast, is dominated not by fast-growing tech companies but by mature stocks. Low interest rates might be great for Meta (US:FB), Tesla or Alphabet, but they are less so for Shell (SHEL) or Unilever (UVLR). And so they are less good for the equity market in total.
The prospect of higher rates, then, is tricky for both US and UK stocks – but more so, perhaps, for US ones.
