With all the talk in recent months about the timing of U.S. interest rates rising, it has been accurately stated that equities typically do well in rising rate environments. What may prove to be a mistake though is the assertion that equities will also perform well the next time (later this year?) interest rates increase.
Why? The next time interest rates rise (later this year?) will be in a much different economic environment compared to previous ones when rates increased. Let me elaborate.
If you click on the graph from HSBC consider the past seven monetary tightening cycles, then you will see how global equities have normally responded in the twelve months before and after an initial rate increase by the Federal Reserve. As stated earlier, stock prices (red line) usually appreciate (by ~7%) twelve months after the initial rate hike.
Looking closely at the graph, this appears to be driven by rising earnings (grey line). In fact, earnings have typically risen faster rate than stock prices after an initial rate increase.
Shouldn’t stock prices grow at the same rate of earnings grow? Not necessarily.
Looking closely at the graph, the price-to-earnings multiple (black line) usually decreases after an initial rate increase. Higher interest rates increase opportunity costs for investors, which understandably decreases the price-to-earnings multiple. As a result, stock prices rise slower than earnings after an initial rate hike due to what CFA-types call multiple compression.
Furthermore, you will see that trailing twelve months (“TTM”) earnings growth before an initial rate hike has normally been ~14%, and TTM earnings growth twelve months after a rate increase has normally been ~16%. In other words, rate increases have typically occurred during periods of double-digit earnings growth. This understandably contributed to the higher stock prices observed during periods of rate hikes.
What does all this mean? It means stock prices are: 1) ultimately driven by earnings growth, and 2) higher interest rates are actually a drag on stock prices. The false expectation of high interest rates driving higher stock prices is not based on the physics of causation but merely a mirage of correlation.
So how could this impact investors going forward? If the cause-and-effect relationship between earnings growth and stock prices continues to hold, then investors should be concerned. After all, most of the companies listed on the S&P 500 are firmly in a revenue recession and are on the verge of an earnings recession, at a time when earnings quality is in decline. If interest rates increase (later this year?) during a period of negative earnings growth, then it would appear reasonable to expect the positive correlation between stock prices and interest rates to not hold.
In hindsight, it appears that the ideal time for higher U.S. interest rates would have been back in 2010 or 2011, which was the last time earnings growth was in double-digits. The Federal Reserve looks like it may indeed be behind the curve. Please consult an investment fiduciary before making any investment decisions.