Interest rates are rising, but it isn’t all bad news for investors

History suggests that if investors take a long view, returns will be positive through the tightening cycle
Furthermore, inflation is likely to peak in the next few months, and the medium-term outlook for equity returns should be healthy

Chris Iggo

Published: 3:30am, 24 Feb 2022

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Rising inflation has been the top concern for investors around the world over the past year. So far, there are few signs inflation is peaking. That means interest rates will rise, which has implications for economic growth, corporate earnings and stock valuations.

Equity investors have already seen significant negative returns in anticipation of higher rates. There may be more to come in the short term. However, history suggests that, if investors take a long view, returns will be positive through the tightening cycle.

The key drivers of returns are what happens to valuations and corporate earnings. In this cycle, some markets could become less expensive, while the outlook for earnings is much more positive.

Both valuation and earnings drivers are cyclical and tend to be weakened during periods of rising interest rates. The US Federal Reserve will soon begin raising interest rates and markets are pricing in six increases in 2022.

In Europe, the European Central Bank is expected to start moving away from negative interest rates this year, while the Bank of England has already pushed its key interest rate up twice. Around the world, the tendency is for interest rates to rise as markets lean against the highest inflation rates in years.

Typically, the beginning of the monetary tightening cycle is bad for equities. Markets tend to de-rate, meaning price-to-earnings (PE) ratios fall. This is driven by the relative valuation between equities and bonds.

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We can calculate the earnings yield on equities by looking at current or prospective earnings per share and comparing that to the risk-free rate available for fixed income markets (usually, investors look at 10-year benchmark government bond yields as the comparison with the equity earnings yield).

If bond yields go up, as they tend to when inflation rises and central banks raise interest rates, then there is a tendency for the equity earnings yield to rise to keep pace and maintain a healthy gap between the two (which can be seen as a proxy for the equity risk premium). A higher earnings yield means a lower PE ratio which, on unchanged earnings, means lower equity prices.

Markets have already adjusted to some extent. The US equity market has been trading at a valuation premium to the rest of the world since the beginning of the pandemic, benefiting from low interest rates, the Fed’s quantitative easing and fiscal stimulus.

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This has fuelled investment in the stock market. Compared to historical averages, indices like the S&P 500 and the Nasdaq Composite are still valued at more than one standard deviation above their long-term averages.

A similar analysis suggests that European and Asian equity markets are either at or below their long-term average valuations. Hence the concern that US markets could still see further downside as inflation and rates move even higher.

It should also be noted that, in higher inflation periods in the past, equity multiples have been much lower than they are today. I do not expect the US inflation rate to remain at the 7.5 per cent recorded in January 2022, but it is likely that for a couple of years, it will be in the 3-4 per cent range.

When inflation has been at those levels previously, bond yields have been higher and PE ratios lower than today’s levels most of the time.

However, some degree of financial repression will probably remain in place as a result of past interventions of central banks in markets, so that the worst-case valuation adjustments are likely to be avoided.

What is key is that valuations tend to reach a new equilibrium early in the rate hiking cycle. Investors should expect inflation to peak in the new few months. If this coincides with lower equity prices and a general further easing of supply-side bottlenecks, markets could bottom out this spring.

Thereafter, it will all be about the messaging from central banks and what happens to growth and earnings. A peak in inflation should mean that no further monetary tightening needs to be priced in. So far, what has been priced in is not damaging global GDP or corporate earnings forecasts for 2022 and 2023.

This means the medium-term outlook for equity returns globally is in the high-single-digit area. The next few months might be dangerous, though with a risk that the S&P 500 slips below 4,000 and the Nasdaq composite to 12,000. European and Asian markets have less downside and can still play catch-up in terms of GDP and corporate earnings growth.

The key is to watch the inflation data and the response in global bond markets. In the worst-case scenario, inflation could continue to surprise, interest rates could rise further and PE multiples in equity markets may decline by even more.

This would bring the risk of recession but would also ultimately provide a good opportunity to buy stocks. And, with a more benign outlook, such an opportunity could come sooner rather than later.

Chris Iggo is the chief investment officer for core investments with AXA Investment Managers

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