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Should US Equity Investors Fret About Rising Yields?

Celia Dallas
Celia Dallas

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

Not in the near term. The current environment of rising, but low, interest rates accompanied by strong earnings growth expectations is supportive for equities. Rising rates create challenges for equities when earnings growth does not keep pace with higher yields, which occurs when rates constrain economic activity. Equity investors should be concerned when rates rise enough to either pressure profitability or make debt service challenging, which typically happens when yield increases are substantial enough to increase the cost of debt relative to income and/or curtail investment. Even as rates remain low today, bond proxies (i.e., defensive, high-yielding strategies such as utilities, REITs, and minimum volatility smart beta strategies) are unattractive.

Dividend discount models highlight that increases in the discount rate for equities tend to result in falling P/E ratios, which can have a large negative impact on returns absent a strong enough improvement in earnings growth. Sensitivity analysis using such models highlights that a 100 basis point (bp) increase in the assumed discount rate knocks down the fair-value P/E multiple of the market by nearly one-third. However, such a loss can be regained by roughly a 100 bp increase in earnings growth. In other words, the impact of rising interest rates on equity returns can be fully offset by a roughly equal increase in earnings growth. Empirical evidence shows that US equities have experienced positive returns in every period in which ten-year yields have risen at least 100 bps since 1995, and in 13 of 17 periods since 1971. Since its bottom in July 2016, the ten-year Treasury yield has increased 155 bps to reach approximately 2.9% today. At the same time, 12-month forward earnings growth expectations have increased by approximately 900 bps, due in large part to the Tax Cuts and Jobs Act of 2017. The net impact on the S&P 500 Index has been a price increase of over 30% with a higher forward P/E ratio (17.9 as of the end of January 2018, compared to 16.6 on June 30, 2016).

Rising rates are unlikely to bite into consumer demand and corporate earnings in the near term. Consumer leverage has reached new highs in absolute terms but, as a percentage of disposable income, is well below 2007 peaks and has been stable since 2012. In addition, debt service remains low: at 10.3%, consumers’ debt service ratio is well below peaks of 12.6% reached in 2001 and 13.2% in 2007, although some portion is floating rate and subject to increase as rates rise. Still, higher wages and income tax cuts—particularly if accompanied by increases in productivity—should increase consumers’ disposable income, as should higher interest income on savings as rates rise. In contrast, the corporate sector has been increasing leverage, though low rates have held debt service costs down to reasonable levels. The impact of rising rates should take time to work through to compressing corporate margins through higher interest expenses. According to analysis by J.P. Morgan, only 11% of debt of S&P 500 ex financials companies is floating rate. The remaining 89% of debt has a weighted average maturity of 10.7 years. In other words, it will take time for higher interest rates to translate to higher interest expenses. Further, higher rates should benefit equities by increasing the interest income on the significant cash balances held by S&P companies and, for financials, by improving net interest margins (provided increases in deposit rates continue to lag increases in cash rates and lending rates, as has historically been the case). Small-cap companies, however, are more vulnerable to rising rates as roughly one-half of their debt is floating rate.

If rates rise due to a shift in supply/demand dynamics, this would be negative for equities, as there is no particular reason why earnings growth would keep pace with an increase in rates necessary to clear the market as more debt supply becomes available. With the US Federal Reserve shrinking its balance sheet, and the European Central Bank and Bank of Japan reducing asset purchases at the same time that fiscal stimulus is increasing, the net supply of newly issued government bonds from these three regions is expected to increase after three consecutive years of net supply decreases. According to estimates from BCA Research, net supply will increase by $957 billion in 2018 and $1.1 trillion in 2019. One potential offset to rising supply is a demand boost from pension funds; further rate increases would boost funding status, and they may seek to lock in this improvement by increasing liability hedging through long-dated bond purchases. The risk to equities from potential bond supply/demand imbalances will increase in the second half of this year into next year, as net bond issuance is scheduled to increase.

Although equities in general should hold up well provided interest rate increases are gradual, the impact on equities should not be expected to be uniform. An evaluation of the last seven periods of rising rates dating back to 1995 shows that defensive sectors tend to underperform, while cyclicals tend to outperform—but there are lots of exceptions. Smart beta bond substitutes (minimum volatility and high dividend yield) pretty consistently underperform during rising rate environments. These strategies have underperformed the broad equity market since ten-year Treasury yields bottomed in July 2016, and we regard it as likely that such underperformance will persist given the attraction these strategies have garnered in a period of low rates. As rates rise, investors that have been “tourists” in these smart beta strategies and defensive equity sectors should be expected to return home to high quality bonds when conditions are more hospitable (e.g., when bond yields have risen enough to provide adequately compelling risk/reward for such investors).

Overall, we don’t think investors should shy away from US equities out of concern for rising rates, but a change in the composition of US equity investments would be sensible, as bond substitutes and small-cap stocks are more vulnerable to rising rates. Investors, however, may want to consider tilting global equity portfolios away from US equities and toward other developed and emerging markets, given relatively better earnings growth prospects and more room for valuation multiple expansion.

Celia Dallas is Chief Investment Strategist at Cambridge Associates

Originally published on February 27, 2018

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