A sudden sharp rise in interest rates in 2021 worried investors, who’d become rather accustomed to low rates after decades at or near historical lows.
While many investors believe higher rates are bad for stocks, history has repeatedly shown that North American stocks have held up pretty well in rising rate environments.
Price-to-earnings ratios — commonly referred to as P/E ratios — are supposedly inversely related to interest rates, but there’s no evidence to support this claim. Going back to 1950, the S&P 500 only declined twice when 10-year rates rose by at least 1% — and by tiny margins compared to the upside moves.
Another concern is increased competition from bonds as yields move higher. Those invested in higher-yielding equities like utilities and REITs might decide it makes sense to shift to bonds and avoid the higher relative volatility of equities. But how many people bought 7% bonds over dotcom stocks in the late 90s?
Higher rates are also said to be bad for growth stocks, but U.S. companies with weak balance sheets outperformed stronger ones in the second half of 2020 by the greatest amount since the financial crisis. It doesn’t make sense that weaker companies could benefit from rising rates while stronger ones suffer, so this doesn’t seem to hold true either.
Rising rates in context
The uptick in long-term rates in the spring of 2021 was a sign of collective optimism that the world was moving past the COVID pandemic – some light at the end of the tunnel.
Q4 2020 GDP numbers were strong and estimates for Q1 2021 were also looking quite good. It’s rather unlikely during a time of heightened GDP growth, that the stock market wouldn’t benefit too, or would actually decline.
It’s rare for the stock market to experience losses while economic growth is above trend. The only serious market selloff that occurred this way was the crash of 1937.
Interest rate levels are important, but changes in those levels are not necessarily a trigger for every market adjustment.
The inflation wildcard
Many have argued that rising inflation expectations are a bigger concern for market participants, since it means future payments won’t go as far because of those higher prices. This makes bonds less desirable and leads their prices to fall, pushing up yields because investors command more to hold them under such circumstances.
Stocks should benefit — at least in the short term — from rising earnings as the global economy recovers from a crisis. But, higher corporate profitability can become inflationary, which in turn increases the likelihood of central bank rate hikes.
While market observers expect inflation to ramp up considerably — especially based on pre-COVID comparisons — any major increase is viewed as unlikely to be sustainable.
What it means for investors
Asset mix determines a lot of the variability in the level of both risk and return that investors will experience over time, and there’s typically a place for both stocks and bonds in most portfolios over the long term.
Bonds tend to provide a cushion when the stock market hits a rough patch since bonds exhibit less volatility than stocks over the long run. But, erring too much on the side of caution by avoiding stocks completely could mean investments aren’t even able to keep pace with inflation.
While rising interest rates might be a negative factor in the short term, they can contribute to growing your returns over the long term. Rather than fear the bond market, equity investors should appreciate the ability to prosper from a stronger economy that boosts earnings and also leads to higher interest rates.
Investors should keep themselves informed, but should also recognize that they don’t need to act on every bit of news or information. There are risks associated with rising interest rates, but having a suitable well-thought out investment plan that makes sense for their goals, objectives and risk tolerance is also key.
“Successful investing is about managing risk, not avoiding it.”