Interest rates have once again become a major topic of conversation among the punditry in the financial media. As the 10-year U.S. Treasury rate, arguably the most followed interest rate in the world, has risen more than a half of a percent year to date a variety of commentators have taken to the airwaves to prognosticate doom and gloom for the equity markets, arguing that rising rates pose a threat to the ongoing equity market rally.
In this commentary, I’ll examine each of the three arguments most commonly proposed today for why rising rates are a threat to the equity markets and share my thoughts on the validity of each.
The first argument makes an appeal to quantitative valuation theory, specifically the discounted cash flow (DCF) model that is used to value financial assets. The DCF model uses a formula to calculate the present value of an expected stream of future cash flows. Whether used to value an individual stock or the market in aggregate, the DCF model requires an analyst to forecast two key variables: (1) the future stream of cash flows to be generated by the company or the market and (2) the discount rate used to discount cash flows to be received in the future to today’s present value given that investors would prefer to have a $1 today vs. a $1 at some date in the future. A higher discount rate lowers the value of future cash flows and thus leads to a lower valuation.
Those arguing that higher rates are a bad thing for stocks point to the DCF model and claim that rising interest rates result in a higher discount rate and thus lower equity valuations. While this is true so far as it goes, in my perspective, proponents of this argument are dramatically oversimplifying the matter by naively assuming that all other variables in the DCF model remain unchanged as U.S. Treasury rates rise. A more thoughtful examination of the model reveals that rising Treasury rates has a decidedly ambiguous effect on valuations given the possibility that other variables in the model also very likely to be impacted by a change in Treasury rates.
The graphic above presents a simplified version of the DCF model. A cursory examination reveals that focusing on just the Treasury rate component of the model ignores a lot of nuance by assuming that everything else remains constant as Treasury rates change. For example, it fails to consider a variety of possibilities including:
- The equity risk premium component of the model (which combined with the Treasury rate component establishes the discount rate) could fall as Treasury rates rise given the possibility that Treasury rates are rising due expectations for stronger economic growth which could lead to lower risk aversion. A decline in demanded risk premiums could fully offset the rise in Treasury rates resulting in a lower discount rate which would ultimately drive higher equity valuations.
- Expectations for future earnings could also increase given expectations for stronger economic growth and/or higher inflation. Higher expected earnings would all else equal lead to higher expected valuations.
- Corporate payout policies could also be impacted by a rise in Treasury rates. Companies may alter their payout policies and choose to distribute either more or less of their future earnings to shareholders in the form of dividends and buybacks based on their outlook for growth and inflation among other factors. Changes in payout policy would have second order impacts of both expected future earnings growth and aggregate payouts, both of which would impact valuations.
Ultimately, it’s clear that the DCF-based argument that higher Treasury rates are, in and of themselves, a threat to equity valuations is overly simplified and doesn’t pass the test of further scrutiny.
A second argument for why stocks are susceptible to rising rates is predicated on a concept that’s been more or less widely accepted over the last decade since the financial crisis: TINA, short for “There Is No Alternative (to stocks).” The TINA concept argues that ultra-low interest rates have resulted in a dearth of return potential from cash and other “safe” assets which has caused return-seeking investors to move further out on the risk-return spectrum (i.e., from cash into investment-grade bonds, from investment-grade bonds into high yield bonds and from high yield bonds into stocks, and so on) which has more or less steadily driven equity markets higher. Accordingly, proponents of the TINA school of thought reason that if low interest rates were the primary driver of the equity market’s rally, then higher interest rates will cause stocks to fall as the process works in reverse as investors at the margin migrate back to lower risk assets that now offer higher prospective returns than before.
This argument, to me, is really just a repackaging of the DCF-based argument that differs in style but not in substance. Whereas above I pointed out how those promoting the DCF-based argument that higher Treasury rates alone are a threat to the equity market are flawed in that they ignore the possibility that the other inputs to the model could change simultaneously to the change in rates, so too is the TINA argument flawed in that it focuses only on one aspect of the DCF model while naively assuming all other variables remain unchanged as interest rates change.
The TINA-based argument effectively focuses exclusively on the risk premium component of the aforementioned DCF model in explaining moves in the stock market. In its base form, it argues the following:
- Low rates --> lower risk aversion --> lower discount rates --> higher stock prices
- High rates --> higher risk aversion --> higher discount rates --> lower stock prices
This line of reasoning suffers from three key flaws in my perspective:
- It suggests that the singular diver of aggregate investor risk aversion is the level of risk-free rates which is highly unlikely to be the case in real life;
- It claims investor risk aversion and Treasury rates move together in the same direction which stands in contrast to the realized experience in markets where we’ve seen just the opposite—investor risk aversion has tended to increase dramatically during recessions when rates are generally falling and has declined during expansions when rates are generally rising; and
- It doesn’t account for the possibility that either future expected earnings or payout policy are also impacted by changing interest rates which, as discussed previously is highly unlikely.
One additional challenge to this line of reasoning that’s yet to be fully explained by its proponents: why have stock market valuations remained considerably lower in non-U.S. markets over the last decade when foreign interest rates have consistently been lower than those at home? Put differently, if low interest rates are the sole cause of high equity market valuations in the U.S., why aren’t equity markets even more highly valued outside of the U.S. where interest rates are even lower?
As a bit of an aside, before moving on, I’ll add that one aspect of this line of reasoning that I believe its proponents have right is their focus on investor risk aversion as the driver of short-term equity market returns. Whereas fundamentals drive equity market returns in the long run, narratives, sentiment and capital flows drive returns in the short run. Thus, to the extent that investors collectively believe in the TINA narrative and/or the previously covered DCF-based narrative as a driver of U.S. equity market returns, both narratives may continue to drive periodic bouts of equity market volatility as interest rates move about.
The third commonly suggested argument for why rising interest rates pose a threat to equity markets is predicated on the belief that the expansionary monetary policy regime of the past decade has led to significant distortions in the allocation of capital across the economy and has given rise to a meaningful number of companies with unsustainable business models that are gravely threatened by higher interest rates. This argument is succinctly articulated by Ross Stevens, the CEO of Stone Ridge Asset Management:
"Just like certain offspring of helicopter parents – those underemployed, glassy-eyed 25-year-olds living in their parents’ basements – who have neither the will, nor ability, nor, in some cases, even permission to leave, the offspring of central bank helicopter money – certain over-levered, glassy-eyed companies in certain segments of over-money-supplied industries – cannot survive without ongoing access to the essentially free USGPM [U.S.-Government-Paper-Money] they indirectly borrow. Like the smooth-kneed 25-year-olds, those over-moneyed zombie firms have neither the will (“when USGPM is free, why bother with financial discipline?”), nor ability (“our business model doesn’t work at higher interest rates”), nor, in some cases, even permission to leave (“you bail us out because we employ so many voters, or because we intermediate and credit-multiply your monetary policy”)."
This line of reasoning argues that rising rates will expose the unsustainability of many of these companies and will force a significant readjustment back to reality which will result either isolated or potentially widespread capital losses. I find this argument the most compelling of the three and is the one that influences our current portfolio positioning.
Put simply, I believe there are unsustainable excesses in markets today which is something I’ve written about in previous commentaries. At some point in the future, I believe today’s excesses will give way to a reversal. As regular readers are aware, I also remain circumspect about my ability (as well as that of other investors) to accurately predict the future with enough pinpoint accuracy to warrant dramatic, wholesale portfolio actions. Remember, recognizing that imbalances and excesses exist in the markets today is only half of the battle. Getting timing right it also critically important for those considering dramatic portfolio changes. Only time will tell how long the current run will continue. As things stand today, both monetary and fiscal policy authorities show no signs on taking their foot off the gas. Accordingly, the current rally may well still have a way to go.
Absent the ability to know for certain when the tide will turn, we continue to recommend portfolio positioning that is (a) modestly defensive that seeks to participate to the greatest extent possible in the overall equity market’s upside potential while incorporating an explicit element of downside protection and (b) that tilts portfolios away from areas of the market exhibiting signs of excess and unsustainability and towards those that appear to be on more sound footing and that as a result stand be relative winners going forward. We will, as always, continue to reassess our view as new developments emerge and will reposition portfolios accordingly.
Kathmere Capital Management (Kathmere) is an investment adviser registered under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply any level of skill or training. The information presented in the material is general in nature and is not designed to address your investment objectives, financial situation or particular needs. Prior to making any investment decision, you should assess, or seek advice from a professional regarding whether any particular transaction is relevant or appropriate to your individual circumstances. This material is not intended to replace the advice of a qualified tax advisor, attorney, or accountant. Consultation with the appropriate professional should be done before any financial commitments regarding the issues related to the situation are made.
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