- Interest rates have risen as investors expect expedited economic growth in 2021
- This sparked a selloff in stocks and bonds as the market adjusts to higher rates
- Ultimately, strong economic growth and moderately increased interest rates are good for both stock and bond investors
After reaching an all-time high in early February, the S&P 500 pulled back over 3% in the second half of February, while the tech-heavy Nasdaq experienced an even sharper decrease of almost 7%. This decline was caused by increased interest rates which impacted all sectors of the economy. The impact on affordable housing, servicing debt and the relative attractiveness of investment opportunities are all reasons why investors pay close attention to moving rates.
What will rising rates mean for the economy and for the performance of stocks and bonds?
2021’s interest rate increase is one of the largest moves since 1962.
Overall, interest rates are still at historically low levels. However, since the start of 2021, the rate on a 10-year US Government Bond has risen by 0.5%. This may sound insignificant, but in reality, this increase is in the top 10% of interest rate moves since 1962. This increase follows the 10-year rate which had already climbed 0.55% over the last four months of 2020. The impact of this move is even more dramatic because the absolute level of rates is so low. If you start at 1%, an increase of 0.5% is a 50% change.
Keel Point examined two-month intervals through history, and starting in 1962 – during periods where the US 10-year rate increased by at least 0.5% –the average return over the next quarter for the S&P 500 was +0.8%. To give a sense of the range of returns in this environment, four out of five quarters saw the S&P 500 return somewhere between -6% and +8%.
Why are interest rates so important to stocks?
One reason that interest rates are vital right now is that low rates have helped to support high stock market valuations. This has happened in two ways:
- Low rates have driven many investors to take more risk as they search for higher returns. This leads to the popular acronym TINA(There Is No Alternative) which refers to the fact that many investors who would normally prefer to purchase bonds have moved into the stock market looking for more attractive returns.
- Low interest rates directly impact the valuation of stocks. When you own a stock, you own a claim on a portion of that company’s future earnings. When you use a lower interest rate to discount future earnings, you get a larger present value. This means that a low interest rate environment can support relatively higher stock market values than a high-interest rate environment. This effect has been magnified for stocks such as Tesla, where a large portion of their value comes from earnings that are expected far off in the future.
To determine the impact of rising rates, it is important to identify the underlying cause. Generally, the two main drivers of interest rates are expectations for inflation and economic growth.
Measures of inflation have increased in recent weeks. However, they remain close to the Fed’s target of 2%. The Fed has stated a willingness to let inflation run above 2%, but if long-term inflation expectations were to become unhinged from the 2% target, it could force the Fed to raise short-term interest rate. This could cause a slowdown in growth and impact the real economy and the stock market negatively. Inflation poses the biggest risk to bonds since bondholders will receive fixed interest payments that become less valuable in an inflationary environment. Stocks typically decline in response to an increase in inflation expectations. However, over longer periods of time, they can be an effective inflation hedge as earnings catch up with inflation.
Growth expectations continue to increase as the economy recovers from COVID-related restrictions. Goldman Sachs recently raised their 2021 GDP growth forecast to 7%, with double-digit growth in the second quarter. This would represent some of the fastest economic growth in decades. Comparing it to the lows of the Financial Crisis, GDP growth did not surpass 5%.
Rising rates driven by higher growth expectations are a sign of a healthy economy. While rising rates can hurt current bondholders, ultimately, higher rates allow investors to earn a more attractive yield on their bond investments.
We already mentioned higher interest rates could reduce the value of stocks. Still, it is important to remember that if strong economic growth is the underlying cause of the move higher in rates, this will benefit corporate earnings and the stock market. Whereas high valuations have been supported by low-interest rates, going forward, they could potentially be supported by future growth.
What should you do?
All of this leaves us with three recommendations:
- Be cautious if you are overly concentrated in any one sector. If you have been overweight large-cap technology stocks, you have likely done very well over the last few years. This is partially because in a low-growth, low-rate world, investors are willing to pay a premium for high-growth stocks. Rising interest rates could lead to a shift in this regime.
- Look for rebalancing opportunities. Market dislocations can present attractive rebalancing opportunities. This is something that we took advantage of last year, and should the current selloff continue, we will look to do so again.
- Stick with your long-term plan. The markets change day to day. The key to success is building an effective long-term plan and staying on track.
At Keel Point, we start with your personal goals and build a customized portfolio to help you achieve those objectives. We work to construct diversified portfolios that are designed to weather a variety of economic regimes.