In a vacuum, higher interest rates mean lower valuations on stocks as their stream of future earnings is worth less when discounted back to current dollars at those higher rates, observes John Boyd, mutual fund strategist and editor of Fidelity Monitor & Insight.
That is why growth stocks, which typically get more of their valuation from future earnings than value stocks, tend to be hurt more from rising rates. But it is important to take into account why interest rates are rising.
In the current case, rates are rising largely because the outlook for the economy and corporate earnings is brightening.
The metrics around Covid-19 have improved substantially (fewer cases, hospitalizations, and deaths) as the vaccine roll-out gathers steam after a rocky start.
On the consumer side, retail sales continue their recovery from the pandemic lows of last April and are now 5.8% higher than a year ago. And the future for retail sales looks strong given that Goldman Sachs estimates that consumers have generated $1.5 trillion in excess savings over the past year.
Similarly, on the manufacturing side, industrial production has fairly steadily improved since April and is now just 1.8% below a year ago. These are just two of the areas that are seeing a return to solid growth as the disruption to the economy from the pandemic has waned.
GDP Growth Nears Double Digits
As a result, over the past few weeks, forecasts of first quarter GDP growth from the Atlanta Fed more than doubled, jumping from 4.5% to 9.5%! Other forecasters are expect-ing a more modest, but still quite strong, gain in GDP.
The significantly improving economy is expected to translate into truly explosive growth in corporate earnings from 2020’s depressed level. Analysts are now forecasting S&P 500 full-year earnings in 2021 to be 44% higher than 2020.
That magnitude of earnings growth (even if it’s some-what less than 44%) is more than enough to offset the negative impact of the higher yields we see today.
Rates: How High Is Too High?
At what point could higher yields really damage stocks? According to an analysis of the past 18 periods of rising rates (prior to the current one) by Lori Calvasina head of U.S. equity strategy at RBC Capital Markets, the line of demarcation is 275 bps (a basis point is 1/100 of a percent).
In 11 out of the 18 periods, the increase in the 10-year yield was less than 275 bps and the S&P 500 aver-aged a 19.7% gain. But in the seven periods where the rise in the 10-year yield was greater than 275 bps, stocks declined by an average of 3.0%.
At 1.44%, the current 10-year Treasury yield is just 93 bps higher than its historic low of 0.51% reached last year. To get to a rise of 275 bps, the 10-year Treasury yield would have to be 3.26%, a rate we are very unlikely to see in 2021.
What About Inflation?
However, part of the worry over rising rates isn’t about today’s rates, or tomorrow’s, but where they might go if inflation gets out of hand.
The fear is that all the stimulus measures (remember the $1.5 trillion in excess savings), and pent-up demand (along with some damaged supply chains) will result in sharply higher prices as the economy returns to “normal.” In that case, the concern is that the Fed will break its pledge to keep rates near zero through at least 2023.
While we could see higher prices later in the year (for the reasons noted before), giving the markets a scare, we do not expect a sustained bout of significantly higher inflation.
There are still too many forces for deflation at play currently — tech-driven disruption, globalization, the decline of unions, and an aging population (retirees tend to spend less) — to allow inflation to really break out. Overall, the market is vulnerable to a set back at any time, but, in my view, the long-term trend remains bullish.
