Will Rising Interest Rates Derail the Stock Market?
Volume 18, Issue 2a
In this Market Update, you will learn:
- When interest rates and stock prices are positively correlated
- How a low-inflation environment affects the stock market
- Our view on how long the markets will continue to trend upward
- Risks that could take the markets off track
By STEVEN HOFFMAN
New Federal Reserve Chairman Jerome Powell has stated that the central bank will continue to gradually raise interest rates. The Fed has raised interest rates five times dating back to December 2014 and is expected add another three or four rate hikes in 2018.
The bond market has followed suit, with the 10-year Treasury yield more than doubling from a low of 1.34 percent in July 2016 to recent highs that are approaching the 3.0 percent level. This prompts the question, “At what point will rising interest rates adversely impact the stock market?”
Historically, interest rates and stock prices are positively correlated when the 10-year Treasury yield is below 5.0 percent. In other words, the stock market and interest rates go up in tandem when interest rates are low.
The theory is that as the economy shifts from a slow-growth or recessionary mode, rising interest rates serve as positive confirmation of an improving economy. It is later in the economic cycle that rising interest rates become restrictive to economic growth as the Federal Reserve aims to keep inflation under control. Inflation has not yet been a problem.
The Personal Consumption Expenditures (PCE) price index has remained slightly below the Fed’s 2.0 percent target for the past five years and is expected to stabilize near the target level over the next few years. A mild inflation environment such as this would allow the stock market to remain focused on corporate profits.
Corporate earnings growth expected to continue
On that note, the S&P 500 companies had their strongest earnings season in years during the fourth quarter of 2017, with profits up 14 percent over year-ago numbers. Additionally, the solid economic environment and the one-time boost from new lower tax rates have analysts now expecting 20 percent earnings growth in 2018 and 10 percent in 2019. Low inflation and strong earnings would likely result in continued strong stock market returns.
The delicate balance between growth and inflation could change with a new wave of investment spending incented by recent tax law changes. With the economy already operating near full employment, the new stimulus could prompt the Fed to hike rates more aggressively than currently anticipated. The chart below illustrates the limited amount of time our economy has been able to operate above its theoretical potential over the past 37 years. The three prior times it attained or exceeded its potential (1989, late 1990s and 2005 to 2007) were all followed by a recession (see shaded areas) within a couple of years.
We will let earnings guide us
In this tenuous environment, we will let earnings guide us, and keep a close eye on inflation and interest rates. If earnings really do grow 20 percent in 2018, a lot of other factors can be less than ideal and the stock market will still go up. Also, the strength of the global economy could prolong this “melting-up” phase longer than historical rallies.
In conclusion, we feel that gradually rising interest rates and continued low inflation will allow the stock market to trend upward over the next couple of years. The efficiencies provided by a strong and open (i.e., no trade wars) global market are key to this scenario. The risks, however, are becoming more defined as rapidly rising inflation and political unrest could take the market off track.
- Steven Hoffman is the Portfolio Manager at Filbrandt Wealth Management.
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