How Rising Rates Will Impact Stocks

by: Russ Koesterich, CFA

While recent market weakness, and the accompanying bond market rally, has tempered fears of an imminent bond market meltdown, many equity investors are still concerned about the potential impact of rising rates on U.S. and global stocks.

This year, I expect long-term rates to rise modestly as they appear too low. Assuming the U.S. economy continues to stabilize over the course of the year, the yield on the 10-year Treasury will likely rise to around the 3% level, roughly where it was last summer.

However, in my opinion, this probable grind higher is not a major threat to U.S. and global stocks this year for two reasons:

Low Starting Point: It’s important to put the current yield environment in context. Excluding the period of unusually high nominal yields in the 1970s and 1980s, the long-term average nominal yield for the 10-year note is still 5.25%, more than twice today’s level. As such, any rise in rates will be coming from historically low levels. And a rise in rates from the absurdly low to the merely low has not, at least historically, hurt stocks. Equity valuations do contract when rates are rising, but this relationship typically breaks down when rates are this low.

The Driver of Rising Rates: In the past, the reason behind why rates rise has been as important for stocks as how much rates rise. Looking forward, the coming rise in rates will likely be driven by higher real rates, not by higher inflation expectations.

When interest rates are rising due to heightened inflation expectations, stock multiples tend to contract. However, when rising interest rates are due to a rise in real, or after-inflation, rates in the context of a strengthening economy, multiples have not been hurt. In fact, over the long term, there hasn’t been a statistically significant relationship between real yields and multiples. If anything, in recent years - which have generally been characterized by too little growth, rather than too much - stock multiples have risen with real rates.

To be sure, none of above suggests that equities have become impervious to higher rates. While higher real yields probably won’t hurt multiples, a high enough rise could dampen earnings. But in my opinion, any rate rise this year should be modest and likely won’t negatively impact valuations. Looking forward, the real threat to stocks in 2012 is weak economic growth, not higher rates.

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