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Higher Interest Rates: Bullish or Bearish?

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Given the strong payroll numbers last week, expectations amongst economists are virtually unanimous that the Federal Reserve will raise its Federal Funds Rate in December. This has the potential to be the first time this interest rate will rise in almost a decade. For most investors, it is not clear how this will impact the stock market though.

A recent headline by Reuters indicated that higher interest rates were a clear sign of a recovered economy, which should be bullish for stocks. Another headline by Bloomberg said it is bearish for stocks given stocks prices in recent years were supported by abnormally low interest rates. As you can see, there is confusion about the impact of higher interest rates on stocks.

As discussed about a month ago, higher interest rates are generally bearish for stocks. For you CFA-types, you know that higher interest rates raise the cost of capital and effectively compress price-to-earnings multiples. Many believe that higher interest rates are bullish mainly because higher interest rates typically occur during times of significant earnings growth, which is currently not the case. Companies are actually in an earnings recession. In fact, the earnings recession is worsening.

higher-interest-rates-bullish-bearish_2015-11If you click on accompanying graph from last week, then you will see that companies in the S&P 500 are in aggregate expected (based on Wall Street estimates) to report negative earnings growth in the current quarter (4Q-2015).

Looking closely, you will see those estimates deteriorated in early last month when companies were still in the early stage of reporting 3Q-2015 financial results.

Though companies in the oil & gas sector are expected to once again lead the decline in earnings, negative earnings growth is forecast to be wide-ranging in 4Q-2015. According to Zacks Investment Research, out of the sixteen (16) sectors in the S&P 500, eleven (11) or a majority of sectors are expected to report negative earnings growth. This includes not only cyclical sectors, which make up most of the S&P 500, but also defensive ones such as consumer staples and utilities.

To summarize, if the Federal Reserve does indeed raise its Federal Funds Rate, this has the potential of compressing price-to-earnings multiples. Combined with the forecast that the earnings recession is worsening, the outlook for the S&P 500 surely does not look bullish. Whether your are bullish or bearish, please consult an investment fiduciary before making any investment decisions.

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