October’s US unemployment report confirmed that the economy is getting stronger, making the probability of a first interest rate hike in December look more likely. In this context, Lazard Frères Gestion examines the consequences of a rate increase on the equity market from two separate angles.
In Chapter I, Julien-Pierre Nouen, Economist & Strategist at Lazard Frères Gestion, provides his macroeconomic viewpoint. Then in Chapter II, Régis Bégué, Head of Research and Equity Management at Lazard Frères Gestion, will share his microeconomic analysis and explain how the expected rate increase will impact securities differently depending on their profile.
An impact, yes, but not a significant one
Data going back to 1919¹ indicate that a one-point variation in interest rates over a one month period corresponds, on average, to a 2.0% fall in the equity market.
The statistical analysis from Graph 1 shows a significant relationship and that rates are indeed a factor in explaining equity market performance. However, rate changes only explain a very small portion of the equity market shifts (around 1%). We get a similar message even if we exclude large rate changes from the analysis.
If we then look at large rate increases and focus particularly on the largest 10% of changes since 1919 (rises in excess of 21 basis points over a month), we can see that on average the equity market reacts negatively, but that there is also a strong degree of variability, and in 45% of cases the equity market actually ended up higher. Moreover, there is no link between the magnitude of the rate hike and the equity market shift (Graph 2).
Two examples: 1994 and Spring 2013
The classic example when analysing the impact of a rate hike on equity markets is that of 1994. At the beginning of 1994, the Federal Reserve started to move towards tightening monetary policy increasing its main refinancing rate from 3% to 6% by the end of that year. At the same time, US 10-year Treasury bond yields jumped from 5.7% to over 8.0% by the end of the same period, which resulted in an approximate 14% drop in 10-year bond prices. As for equities, the S&P 500 Index lost 1.5% over the year and experienced a maximum drawdown of 8.9% between the start of February and the end of March. Overall, given the extent of the bond market collapse, the equity market reaction was modest.
The 2013 “Taper Tantrum” is another example. It was prompted by Ben Bernanke announcing in the Spring of 2013 that the Federal Reserve may begin reducing its asset purchases. Rates rose from 1.7% on April 26th, 2013 to reach 3.0% by the end of December in the same year. Over the same period, S&P 500 Index gains exceeded 16%.
The influence of inflation
Historically, the correlation between inflation rates and equities isn’t stable (Graph 3). The correlation was positive in the early 30s, between 1955 and 1965, and from 2000 onwards. These timeframes correspond to periods of deflation or weak inflation. However, the correlation is mostly negative when inflation is high.
- When inflation is high, monetary policy is implemented to slow growth in order to lower inflation, which is a bad sign for equities.
- In periods of low inflation (as is currently the case) long-term rates depend more on economic developments than on inflation. A rise in rates is therefore seen as an improvement in the economic situation, which is positive for equities, whilst lower rates correspond to periods of economic slowdown, during which corporate earnings suffer.
Since 1984, rises in the federal funds rate entail rises in equities
The high inflation years of the 1970s led the Federal Reserve, under Chairman Paul Volcker, to increase rates sharply so as to strangle growth in a bid to break the inflation spiral. Once the threat of high inflation had diminished, monetary policy responded to the economic cycle rather than to inflation risks. In this context, when the Federal Reserve raises rates, it is because the economy is improving. In turn, broadly speaking, company profits tend to follow suit. Rate-rising phases have therefore predominantly coincided with positive periods for equity markets (Graph 4). That said, the current situation may differ somewhat given that the Fed’s rate hike will be arriving relatively late in the economic cycle.
In summary, a rise in rates, as long as it is not in response to an inflation spike, is not a threat to the equity markets. So far, our research has chiefly relied on US data, thereby allowing analysis over a longer timeframe. However, conclusions for the Eurozone should not be any different. If monetary policy remains accommodating in Europe, then a rise in US long-term rates coinciding with a Federal Reserve rate hike should be reflected in European long term rates. This backdrop of rising rates could lead to significant rotation in equity markets.
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