How Have Stocks Performed Historically Under Rising Interest Rates? 

The short answer is better than many would expect, but it depends on the regime and other events happening at the time.

Where does the fear of rates originate? Aside from the more restrictive financing costs for businesses and consumers, rising rates and/or changing Fed policy can provide a shorter-term jolt to risk assets, largely due to the impact of higher discount rates pulling down the modeled fair values for income-producing assets. In the past decade, the mere removal of extremely accommodative policies, in an effort to get back to some sort of normal (conditions not requiring emergency measures) signified a form of ‘tightening’.

For the most part, central banks and markets elevate interest rates in response to stronger economic growth and/or inflation—each of which needs to be cooled from overheated levels. As stronger economic growth has historically coincided with positive corporate earnings growth, decent equity returns in these environments isn’t that surprising. Inflation is another matter. Beyond a certain level, sustained high inflation can be perceived as more of a headwind. This is not only due to higher interest rates that are assumed to accompany inflation, and lower fair valuations due to present value of money effects, but also the tangible effects of rising costs of wages and goods inputs, which lower corporate profits. As long as the effects of growth outweigh the negatives of higher costs, positive stock results make sense.

However, as the business cycle matures, and economic growth begins to wane, an economy can become more sensitive to inflation and rate effects. This raises another fear about rising rates—in that a central bank will make a policy error and hike too much, pushing the economy into recession. On the positive side, such slowing can prompt central banks to pause rate hikes and/or begin a reversal if this slide starts to occur (and they act accordingly). Recessions have tended to be far worse for earnings growth (and equity prices) than any rising rates (which occur during stronger economies). This data will no doubt be closely watched by the Fed this year, as central banks tend to avoid tightening into a weakening environment. Still-elevated inflation remains the wildcard, something the Fed feels compelled to react to the longer it persists from merely ‘transitory’ status.

As you can see from the tables below, rising interest rates and/or a tightening Fed haven’t necessarily meant doom and gloom for the stock market. Keep in mind, though, that all returns are regime-dependent, with different underlying growth rates, base interest rates, and inflation. (Note that Fed movements prior to the last few decades were much less transparent than they are today; at times before 1979, target rates weren’t always announced. Markets seem to be have become more skittish in recent years in keeping with the high level of communication about rate movements.)

In these types of environments, cyclical ‘value’ stocks have often appeared more attractive than ‘growth’ stocks with lower yields—which can see elevated valuations due to low interest rate inputs. Additionally, floating rate assets obviously have seen greater investor interest, as they benefit from the ‘float’ higher in yields. Ironically, traditional bonds themselves eventually become more attractive, since longer-term returns are so heavily reliant on starting yields—so higher starting yields mean better return potential.

Market Note:

Many of us have lived through multiple financial market corrections, so there is little new to say about the discomfort, other than that these are normal and a healthy part of the price discovery process in any asset market. (Although that doesn’t always provide much consolation for investors.) By contrast, markets that go up forever without occasional pauses to refresh don’t find themselves as healthy. This can inflate financial bubbles, which, when burst, can cause even more catastrophic damage.

From its high in early January, the S&P 500 has reached the -10% correction level. However, this is a small blip on the much larger chart. From a low in March 2020, as fears over Covid turned into business shutdowns and economic decline, followed by a sharp recovery, large cap U.S. stocks had risen about 115%* to that peak. (Small caps were up a stealthy 145%*.) The lingering scars of the pandemic appear now largely isolated to the leisure and travel sectors, if one doesn’t count the inflationary pressures from supply/transportation logjams and fiscal stimulus. These gains were first led by valuation multiples expanding on ‘hope’, but backfilled by the fundamental input of strong earnings growth. This continues today, with 2022 expectations for earnings growth to remain above-average, albeit not to the levels of last year.

‘What is the Fed going to do?’ is the only question that seems to matter lately. Looking at past corrections, central bank and interest rate policy falls right in line with catalysts for uncertainty, along with elections and geopolitical events. The consistent theme among them all is ‘surprise’ or ‘uncertainty’—two things financial markets dislike about as much as anything. A poor environment with more certainty may experience less price volatility than a good one with more possible divergent future paths (we appear to be in more of the latter than the former). The positive outlook for earnings growth, even if not as great as last year, provides support to the current trend that a drop-off in earnings (such as that seen any expectations for a recession) would not.

Corrections on the order of -10% to -15% have tended to occur every 1-2 years, more or less**. They never feel like they happen as often as they actually do, which is why their occurrence, often after periods of calm, tend to be unsettling. If conditions happen to worsen in the near term, -20% ‘bear markets’ are far less common, happening about every 6-7 years. The Feb.-Mar. 2020 drawdown of -34% certainly qualifies as one of the more extreme drawdowns since World War II (one of only six beyond -30%, which have tended to be once-a-decade events). The more severe drawdowns are memorable, as they’ve been coupled with severe economic disruptions, such as oil embargoes, war, the Great Recession, and Covid. However, the 1987 and 2000 market declines were largely tied to financial excesses and subsequent falls back to earth.

Often, market recoveries are charted as peak-to-trough and trough-to-peak, etc. However, we’ve shown this data differently in the table below—returns after various points of decline have been reached. On average, periods following drawdown levels being reached have tended to be better as opposed to worse.

Valuation another worthwhile topic at times like this. P/E is a common metric, with equities entering the year at elevated levels compared to history, but these should be modeled given current interest rates, which are a primary input into classic dividend discounted models. Historically, an ‘earnings yield’ (inverse of the P/E ratio) has been a common way to review the relative attractiveness of stocks vs. bonds. Adapting this to an after-inflation ‘real’ differential provides insight as well. Based on these metrics, with still historically-low interest rates, stocks don’t look as expensive as they otherwise would—and in fact look to be in an appropriate range. However, if inflation and rates tick significantly higher, some re-pricing could be appropriate (as has been happening already).