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Rising Rates: What Does it Mean for Stocks?

Thomas BalisMarch 9, 2018

Investments

Many clients are asking about the impact of rising interest rates on their portfolios these days.  With increased volatility in the markets this year, some are concerned specifically about the impact to equities. While we believe overall economic conditions are favorable for stocks, rising interest rates may, indeed, have some impact upon equity returns.

When the Fed raises the federal funds rate, fixed income investments are most strongly influenced. For more on this, see my colleague’s blog from 2 months ago: (Bonds in a Rising Interest Rate Environment). Because yields on subsequently issued Treasury bills and short term bonds tend to also go higher, investors sometimes begin to find these products more attractive. They may, in fact, sell equities to reduce risk and volatility, settling for the improved yields on safer instruments, such as treasuries.  This selling, at the macro level, can lead to decreasing equity prices.

In addition, increases in the federal funds rate can make it more expensive for companies to borrow. When the Fed raises rates, it does so primarily by raising the federal funds rate, which make up the overnight bank-to-bank lending rate. When it becomes more expensive for banks to borrow from each other, they tend to raise the rates they charge on loans, or scale back on the loans they offer. Both of these outcomes increase borrowing costs for companies, which reduces their profitability. Corporate earnings are a key driver of equity prices, so when earnings go down, so do stock prices.

Finally, higher rates reduce the value of future cashflows for companies, which can lead to lower stock prices. When Wall Street analysts calculate a price target on a stock, they often do so by projecting future cashflows based upon each firm’s existing financial statements. Because a dollar will be worth less five years from now than it is today (remember when gas was $1 a gallon?), they discount those future cashflows to what they would be worth today. While a variety of factors go into what can be used as a discount rate, rising interest rates always lead to higher discount rates. Thus, the current target price put on stocks is decreased. In aggregate, when institutional investors decrease the value they place on a given stock, it could lead to more selling in the market, which generally drives down stock prices.

Nevertheless, we concur with the generally optimistic sentiment on equities for 2018. “The conditions for additional rate hikes in 2018 — wage growth and inflation trending higher, coupled with robust job growth — are favorable for stocks,” says Liz Ann Sonders, Senior Vice President and Chief Investment Strategist at Charles Schwab & Co. “Although inflation is often seen as a bogeyman for stocks, it’s not typically until inflation overheats that trouble ensues.” It is our view that the overall positive impact of these conditions on stock prices will outweigh near term pressures brought about by short term rate increases.

Even so, rising rates do give us yet one more reason to stay diversified and to stick with our long term strategic asset allocation. With periodic rebalancing, changes in equity prices give us the opportunity to buy things on sale, and take profits where needed. If you have questions about your portfolio, or would like more information, please reach out to us at (610) 651-2777.

Sources:

HFA Article – Bonds in a Rising Interest Rate Environment
Charles Schwab – Fed Rate Hike: What Does It Mean for Your Portfolio?