What Will Rising Interest Rates Really Mean for the Stock Market

What Will Rising Interest Rates Really Mean for the Stock Market?

Interest Rates at the Top of the Wall of Worr

Predictions Proven Wrong

What Will Rising Interest Rates Really Mean for the Stock Market?

Long before Greece and China started making the largest headlines every day, investors everywhere thought rising interest rates would cause the next big market decline. (As my father always says, trouble comes from where you least expect it.)

Now that Greece has secured a respite from its lenders, interest rates are moving back to the top of investors’ list of things to worry about—especially since Janet Yellen just reiterated last week that the Fed expects to begin raising rates by the end of the year.

Headlines on CNBC.com last week included:

    Fed Rate Hike Fears Ripple Through Canada, World

    Traders Watch for Whiff of Inflation

(Inflation is one of the metrics that will affect the timing of the Fed’s first rate hike.)

Interest Rates at the Top of the Wall of Worry

However, interest rates have been at the top of the wall of worry so long that it’s likely the effect of the rate hike (likely to be tiny) on the stock market will pale in comparison to the effect the anticipation has had—especially when you consider that investors have been waiting for a rate hike since about 2009. Don’t believe me? Check out what one StreetAuthority analyst wrote in December 2009:

    “We’re only here now because the Fed had to dispense an emergency dose of monetary drugs to keep the U.S. economy from flat-lining. But the patient has begun to recuperate, and sooner or later Bernanke and the Fed will have no choice but to stop the medicine. Keep in mind, we have a long way to go just for interest rates to return to normal—let alone elevated levels needed to choke off inflation. So once the rate tightening cycle begins, don’t expect to see just one or two quarter-point hikes. The last time rates sunk to 1.00% in 2004, they were ratcheted upward 17 times during the next two years.”

Seventeen rate hikes in two years is a far cry from the falling yields we wound up getting in 2010 and 2011 (and again in 2014). To their credit, most experts did start changing their tunes and softening their tones as their predictions were proven wrong by the passage of time.

FOMC members are now predicting a “gradual” pace for interest rate hikes, and a “normalizing” of the rate closer to 3% than the 4% we got used to in previous decades. Most experts are now calling for the same thing, revising their earlier calls for fast and furious interest rate increases.

Still, headlines like the ones on CNBC contribute to the perception that any interest rate increases will be bad news for the market. A recent article on Business Insider attested that, “Higher rates mean higher interest costs, which should be bad for profits and ultimately stocks.”

Predictions Proven Wrong

However, history doesn’t support this claim. Take a look at this Deutsche Bank chart of average S&P 500 returns in the six months after the Fed’s first rate hike:

s&p

The dotted line marks the first rate hike in each tightening cycle since 1983; the left side of the chart shows the average performance of the S&P four months before the first hike and the right side of the chart shows the index’s average performance over the following six months.

As you can see, the S&P tends to do pretty well in the six months after the Fed begins raising rates.

Here’s a second chart created by Allianz Global Investors that tracks market for slightly longer after the rate hikes begin:

return-equities

Again the dotted line marks the first rate hike of each tightening series since 1983, but this time the left side of the chart shows the average performance of the S&P over the six months preceding the rate hike, while the right side shows how the index did over the next 270 days (about 9 months). Again, this is not what you’d expect to see if Fed rate hikes were bad for the market.

Lastly, going further back in time, all the way to 1946, the analysts at Al Frank Asset Management have examined average stock returns one year after the start of 16 individual Fed tightening cycles. You can see their findings in the table below:

capital-iq-tightening

The S&P fell in only five of the 16 twelve-month periods, and it gained over 20% in five of them! (Also, the lowest positive return, 4.8% in 1994, followed a rate hike for which the Fed prepared investors particularly poorly.)

In sum, there’s little reason for equity investors to fear rate hikes. The headwind of higher interest rates is typically overpowered by the tailwinds of economic growth, inflation and higher corporate profits that led the Fed to raise rates in the first place. Or, as longest-serving Fed Chair William McChesney Martin once put it, “The Federal Reserve’s job is to take away the punch bowl just as the party is getting good.” If the market and economy weren’t capable of standing on their own yet, the Fed wouldn’t be raising rates. So while the financial media needs something to panic about now that Greece has backed away from the cliff, you should feel comfortable ignoring their fear-mongering headlines.

P.S. I’ll be diving more deeply into this topic in my talk at the Cabot Investors Conference this August. My presentation, “The Best Income Investments to Own When Interest Rates Rise” will address the effects of rising rates on far more than equities, so you know what investments you should own—and which ones you should avoid—come the Fed’s first rate hike. If you’re concerned about the effect of rising rates on your own portfolio (some asset classes are likely to suffer) just click here to find out more.

Your guide to a secure retirement, 

 Chloe Lutts Jensen,

Chief Analyst, Cabot Dividend Investor

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