Rising Interest Rate Concerns

Of increasing concern for the stock market of late has been anxious focus on the potential wind-down of the Federal Reserve’s long-standing monetary policy known as quantitative easing, or “QE”. QE has involved massive bond purchases by the Fed to keep interest rates low and stimulate economic growth. Some investors are concerned that ending this program would result in a rapid rise in interest rates which would be damaging for the valuations of financial assets, especially bonds.

While there is a clear and visible risk for bonds in a rising interest rate environment, history shows this is  not necessarily the case for stocks. Historically, stocks have been able to overcome rising interest rates and continue to appreciate in the face of rising interest rates. We recently analyzed seven (rising) interest rate cycles going back to 1967. What we found was that, on average over these seven rate cycles, the stock market was up 7.7% in the twelve months and up 17.7% in the twenty-four months following the bottom in rates. 

Why would stocks go up during a period of rising interest rates? There are several reasons for this:

1.       In most of the periods analyzed, the economy was either strong or recovering and, therefore, corporate earnings were rising.

2.       Stocks are viewed as a hedge against inflation because corporations can raise prices for their products and pass some of this on to investors via growth in earnings and dividends.

3.       Growth companies have greater potential to increase their book value faster than inflation and thereby provide better return potential relative to fixed income investments (i.e. bonds).

From a financial planning perspective, the analysis leads us to believe that this cycle should probably not be much different from earlier cycles. There may be a period of market “turbulence” or even a market correction as the Fed begins to taper its QE program; however, as of now, the economy appears to show little sign of recession, we believe corporate earnings will continue to grow, and we expect inflation will remain moderate. This leads us to conclude that equities, particularly growth stocks, should continue to remain an important component of a diversified portfolio.