Why stocks rely on interest rates staying low

Chart of the week

Low real interest rates have been a driver of stock-market valuations in recent years. That need not spell trouble for 2021.

After the devastating stock-market slump in the spring, the forceful recovery in the prices of risky assets since March has caught many by surprise. Following the strong upswing during the summer months, equities took a breather in September and October before resuming their rally in November. With gains of 11.9%, November 2020 ranks as the second strongest month for global equities since 1970, as measured by the MSCI World Index. Only in January 1975 was there an even larger increase.[1]

The strength in markets partly reflects improving prospects for economic recovery, which delivers a significant growth in corporate profit expectations for 2021 (albeit from this year’s depressed levels). However, rising earnings estimates were not the only driver. Equity valuations rose, too. One could argue that at the beginning of a cycle the prospect of a profit recovery is regularly anticipated through higher valuation multiples, notably rises in the price-to-earnings (P/E) ratio. But even taking this as a yardstick and using 2021 consensus earnings estimates suggests equity valuations are well above the historical averages.

One reason for this can be gleaned from taking a glance at bond markets, as our Chart of the Week shows. For several years now, there has been an interesting, inverse correlation between U.S. equity valuations and real government-bond yields (that is, nominal yields adjusted for expected inflation).

Of course, caution is always required not to confuse correlation and causality. In this case, however, we believe there are good reasons to suspect a causal relationship. The sharp decline in bond yields is forcing many investors to look for alternatives and consider switching to other, riskier investments. Which means that the two main risks for a continuation of the positive performance can be identified. On the one hand, of course, there is the further economic recovery, which depends to a large extent on the rapid deployment of efficient, safe and widely available vaccines. On the other hand, real yields would need to remain low. Central banks can make a significant contribution to this, by keeping nominal interest rates low, while allowing inflation expectations to rise. "Since we are convinced that the interest-rate environment will remain low beyond our forecast horizon of one year, we have decided to reduce our estimate of the risk premium for equities. That, in turn, results in higher target P/E ratios at least for the coming year," explains Thomas Bucher, DWS equity strategist.

20201204_CotW_Equity valuation vs yields_CHART_EN_72dpi.png

*Treasury inflation-protected securities
Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 11/19/20

Appendix: Performance over the past 5 years (12-month periods)

11/15 - 11/16 11/16 - 11/17 11/17 - 11/18 11/18 - 11/19 11/19 - 11/20
MSCI World Index 3.2% 23.7% 0.1% 14.5% 14.5%

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 11/30/20
Past performance is not indicative of future returns.

1 . Source: Bloomberg Finance L.P. as of 12/2/20


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