Raising Interest Rates Effect On Stock Performance [Infographic]

by: Kirk Du Plessis

Summary

Many investors expect stock prices to decline when the interest rate increases.

However, historical data shows that in most cases both stocks and bonds perform well during the year leading up to a rate hike cycle and the year after.

Key point: It is very difficult to predict stock performance based on rising or falling interest rates.

Our infographic allows you to look into the past and make inferences based on historical data from past rate increases.

Infographic provided by Option Alpha

When interest rates go up, it has an impact on many parts of the U.S. economy - and the stock market. Shrinking the money supply makes it more expensive to borrow money, which causes consumers and businesses to cut back on their spending. This often leads to a reduction in the valuation of companies and their stocks because the cost of doing business goes up while profits tend to decline.

Combine a reduced money supply with lower company valuations and the stock market becomes less attractive to investors. So it's not surprising that when the Federal Reserve raises interest rates (usually to tamp down on inflationary pressures), many investors expect stock prices to trend downward. However, historical data shows that not only do stock prices fail to show an overall decline during rate hike cycles, they almost always perform well during the years before and after a rate hike cycle.

In a study of six rate hike cycles between 1983 and 2004, the S&P 500 index performance took a downturn in only a few cases. In fact, when measured 500 days after the initial rate hike, average index returns during this time period exceeded 14%.

S&P 500 Index Returns Before and After Rate Increases

In general, equities perform well before and after interest rate hikes. However, researchers discovered that their solid performance is usually accompanies by periods of consolidation and increased volatility. This suggests that when investment decisions made before, during and after rate hike cycles should take not use historical rates of return as the sole decision criterion.

Bond Performance

U.S. bonds (as measured by the Barclays Aggregate Bond Index) also performed surprisingly well before and after an interest rate hike. Average returns were slightly higher during the 12 months after a rate hike cycle than in the 12 months before the first rate hike. In both cases, average bond returns exceeded average returns for all time periods.

Time period Average total return

12 months before the first hike of a cycle 10%

12 months after the cycle ends 11.4%

Average for all time periods 7.32%

To understand the true value of how bonds perform over time, investors often use the compound annual growth rate (OTCPK:CAGR). This mathematical formula shows what an investment yields on an annually compounded basis at the end of a defined investment period. In the case of bonds, it measures the annual return after adjusting for inflation. According to the historical data, 5-year treasury notes produce higher CAGRs than long-term treasury bonds.

Compound annual growth rate for bonds during the last eight rate hike cycles:

5-year Treasury notes - 2.6%

Long-term Treasury bonds - 0.3%

Overall average - 2.5%

Comparative Performance During Rising Interest Rate Cycles

Which type of investment offers the best returns before and after rate cycles? In a study comparing the S&P 500, Barclay's Aggregate Bond Index, long-term government bonds and a diversified portfolio:

  • The S&P 500 had the highest average returns both one year before and one year after the rate hike.
  • The S&P 500 also led the way in average 12-month rolling returns.
  • A diversified portfolio earned the highest weighted CAGR (slightly 1% higher than the S&P 500).

Global equity prices also trended upward before and after interest rate hikes, and declined during the rate hike cycle.

S&P 500

Return one year before rate hike 18.0%

Return one year after rate hike 14.6%

Weighted CAGR during rate hike 8.0%

Average 12-month rolling return 12.5%

Barclay's Aggregate Bond Index

Return one year before rate hike 10.0%

Return one year after rate hike 11.4%

Weighted CAGR during rate hike 2.6%

Average 12-month rolling return 7.3%

Long-Term Government Bonds

Return one year before rate hike 11.5%

Return one year after rate hike 12.6%

Weighted CAGR during rate hike 0.8%

Average 12-month rolling return 8.8%

Diversified Portfolio

Return one year before rate hike 15.0%

Return one year after rate hike 13.8%

Weighted CAGR during rate hike 8.7%

Average 12-month rolling return 9.5%

Global Equity Prices

During the run-up to rising interest rate cycles ↑ (Up)

During the rising rate cycles ↓(Down)

After the rising interest rate cycles ↑ (UP)

Market Sector Performance Relative to the S&P 500

Although stocks generally perform well during rate hike cycles, the performance can vary significantly depending on the market sector of the stock. During rising interest rate cycles, deep cyclical market sectors (companies whose earnings and revenues are significantly impacted by the economic cycle) outperformed the S&P 500, while defensive sectors (companies that produce goods and services people need irrespective of economic conditions) underperformed.

% over- or underperformed during the last seven interest rate tightening cycles:

Energy: +8.5%

Materials: +6.2%

Industrials: +5.5%

Technology: +3.5%

Consumer Discretionary: +3%

Healthcare: +1.3%

Consumer Staples: +.8%

Financials: -.5%

Utilities: - 2.5%

Telecom Services: -3.4%

Real Stock Returns by Decade After Inflation

Experienced investors know that the true measure of stock performance is the real return, which equals the return rate minus the inflation rate.

1950's: S&P 500 21% Inflation 2% Real Return +19

1960s: S&P 500 8.7% Inflation 2.4% Real Return +6.3

1970s: S&P 500 6.2% Inflation 6.1% Real Return +.1

1980s: S&P 500 18% Inflation 5.2% Real Return +12.8

1990s: S&P 500 19.1% Inflation 3.9% Real Return +15.2

2000s: S&P 500 1.2% Inflation 3% Real Return -1.8

2010 - 2016: S&P 500 13.4% Inflation 2.5% Real Return +10.9

The data also showed that stocks tend to perform better during periods of declining inflation rates, but average returns during periods of rising rates were also positive. The worst period for real returns occurred during the 2000's, when rates were declining.

1947 to 1981 - 33 years of rising interest rates

Average return after inflation: 6.95%

1982 to 2016 - 35 years of declining interest rates

Average return after inflation: 8.74 %

Beware of Trying to Predict Performance

Taken as a whole, the data suggests there is a lot more to predicting stock performance than just rising or falling interest rates. That shouldn't come as a surprise considering interest rates represent only one of many different factors that determine the price and performance of stocks.

Additionally, these factors can interact with each other in many different and unpredictable ways. Although historical data shows that stocks generally do well before and after a rate hike cycle, savvy investors take into account all factors before making investment decisions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.