Why investors shouldn’t fear a rising-rate environment, in one chart
Is one of the biggest headwinds facing markets actually something investors should be embracing?
The recent turmoil in the U.S. stock market—highlighted by the Dow Jones Industrial Average DJIA, +1.01% and S&P 500 index SPX, +1.35% dropping into correction territory—was sparked by data that showed wages rising at their fastest pace in years. That underlined concerns that inflation could be returning to the economy, which might force the Federal Reserve to be more aggressive in raising interest rates.
An economic environment with higher rates is considered one of the biggest question marks facing Wall Street, and an “inflation-induced bond crash” was cited as the biggest risk facing stocks by portfolio managers polled by B. of A. Merrill Lynch. But how big of a headwind do high rates really represent? According to one analysis, not big at all. In fact, they may even be a positive.
Despite the recent turbulence, historically, “equities have gained significantly in periods of rising rates,” wrote Jodie Gunzberg, managing director and head of U.S. equities at S&P Dow Jones Indices, in an email. “Since 1971, the S&P 500 has gained about 20% on average in rising rate periods, has gained 8 of 9 times and has gained nearly 40% twice, with less than a 4% loss for its worst rising rate period.” Gunzberg’s analysis evaluated the benchmark U.S. index on a total-return basis.
While many analysts are concerned that high rates could lead to a recession, Gunzberg was more optimistic about such an environment. While there’s more upside in falling-rate environments, “If there is accelerating growth and inflation, like now, rising interest rates can result in appreciating assets,” she wrote.
“Since the rising rates are happening in a profitable economy with strong growth forecasts and increasing dividend payouts (with an extra boost from the income tax reduction), the variables impacting the equity duration are moving to love stocks rather than hate them. This makes sense because interest rates may not drive equities but both can rise concurrently from the environment that lifts them.”
Per her analysis, for every 100 basis point increase in interest rates, every sector, investment strategy, and market-capitalization size category rises. Small stocks see the biggest gain, rising an average of 7.3% on every 100 basis-point rise, while mid-cap stocks gain 5.9% and large-cap stocks advance 2.5%, on average.
“The growth acceleration that cancels the negative equity duration is the same growth that propels small-caps so much, putting them in a leading spot to rise with interest rates – especially since monetary policy is not too tight so that rising interest rates don’t hinder the borrowing by small companies too much,” Gunzberg wrote.
There are signs that investors concerns over inflation are already starting to wane. U.S. stocks rallied on Wednesday, shaking off earlier weakness that followed a reading of January consumer prices showed the strongest monthly rise in five months. However, the 12-month rate of core inflation was flat at 1.8%, a level that is below the Fed’s 2% target.
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