How interest rates affect sharemarkets

Photo of Jon Reilly By Jon Reilly

min read

Bond rates are an important input in the process of valuing stocks.

When we think about the two main asset classes in portfolios, we generally regard stocks as volatile, and bonds as stable. On that basis, investors rightly expect to be compensated for the volatility in stocks with higher long-term returns, and accept lower returns for the smoother ride afforded by bonds.

However, these two asset classes should not be considered in isolation. In reality, bond rates are an important input in the process of valuing stocks.

When we buy a stake in a company, we become a part owner of that business and are entitled to share in its future profits. To assess the current value of those future cash flows, and hence value the stock relative to its current price, we traditionally use the interest paid on bonds as the rate at which we discount the future income.

Higher bond rates mean a bigger discount is applied to those payments, and the maths then leads you to lower valuations on stocks.

Of course, if investing and asset allocation were that straightforward, all of us, armed with some data and a spreadsheet, would be consistently making perfect decisions. However, we know that is not the case and that the world of investing is a more complicated place. Therefore, we need to think about our asset-allocation decisions in a broader context.

Global interest rate outlook complicates picture
Unfortunately, there is more bad news for those looking for simple models and mechanistic decision making: the world has been an unusually complex place in the years following the global financial crisis of 2008-09.

Interest rates in much of the developed world have been at zero per cent for many years, and while the US may well raise rates later this year for the first time in almost a decade, Europe and Japan are stuck at zero percent and will have to unwind their current quantitative easing programs before they increase their rates.

As a reminder, quantitative easing is the policy response of central banks to support a struggling economy when cutting rates to zero per cent proves insufficient. The central banks became large buyers of bonds and this additional demand pushed interest rates lower, with the expectation that lower borrowing costs would support homeowners with mortgages, boost business borrowing and lead eventually to a sustainable economic recovery.

In Australia, we were beneficiaries of continued strong demand for our resource exports following the financial crisis, and the boost this provided to our economic growth meant we avoided the deep recessions seen elsewhere in the developed world.

In monetary-policy terms, it also put the Reserve Bank in the enviable position of being able to make much more modest rate cuts and to maintain relatively higher interest rates, leaving capacity to make the cuts we have seen recently as the mining boom receded.

Chart 1: How Australia’s official cash rate compares to the US

Source: Implemented Portfolios

Positioning portfolios to benefit
Decisions on allocating between stocks and bonds will still be a function of the valuation models mentioned above, though obviously with different inputs.

In the US, the economy has responded to the extraordinary policy support with steady if unspectacular growth and a much stronger labour market. The latter, however, only reflects one of the two aspects that together comprise the dual mandate of the Federal Reserve. In addition to enacting policy that promotes full employment, the Fed targets price stability, interpreted as a steady rate of inflation averaging two percent over time.

While the central banks have control over cash rates, it is market expectations on inflation that are a critical element in how bond rates move, particularly at longer maturities. As best we can tell, the consensus among voting members of the Fed’s policy committee is that they expect inflation to reach their target in the near future, hence the impetus to move on rates sooner rather than later.

We spoke above of demand for bonds being supported by central bank buying, which in turn supressed yields and pushed investors seeking a return on their money to more risky investments. The performance in recent years of higher dividend-paying US stock sectors such as utilities and higher risk credit is evidence of this phenomenon.

We now need to consider the reversal of that environment, with the central bank no longer a buyer of bonds and the marginal new dollar of investment more likely to be allocated to traditional defensive investments as interest rates rise.

The Australian outlook
The Australian experience has again been quite different from that of the US in recent years, with no recession, cash rates at an historic low (but still relatively high) and our sharemarket yet to reach or exceed its pre-crisis peak.

A note of caution is warranted for those attracted to potentially higher income returns on bonds and thus considering increasing their portfolio allocation to this asset class. When you buy an individual bond, then, absent a credit default event, you know with absolute confidence your future performance when you make the investment.

If, however, you invest in a portfolio of bonds via a managed fund or an exchange-traded fund, the manager of that portfolio will be buying and selling bonds consistent with the mandate. Such investments have enjoyed a 30-year bull market as interest rates have steadily declined over that period, adding capital returns to the regular income.

A rising rate environment is, all other things being equal, likely to lead to capital losses that, depending on the particular bonds in the portfolio, may even exceed the income returns and lead to overall negative performance.

Sector allocations in the equity market should also be carefully considered, and here it is useful to look at the historical experiences of the sectors when rates have been rising.

Again, in the context that these rates are rising in response to an improving economy, it stands to reason that cyclical sectors fare quite well. These typically include financials, industrials and information technology, and traditionally energy and materials -- though on these you should also consider the health of the economy to which they are being exported.

Just as utilities were highlighted as faring well in the low-rate environment above, they have been relatively poorer performers when rates increase, as have traditional defensive sectors such as consumer staples and healthcare.

Sound portfolio management requires a thorough understanding of the economic and market environment, and sensitivity to the relative valuations between asset classes and within sectors of the equity market. Above all, patience and flexibility will generally leave you well placed to produce the steady returns required by long-term investors.

About the author

Jon Reilly is chief investment officer of Implemented Portfolios, a leading portfolio-construction and investment-management company.

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