"Don’t fight the Fed" is an old stock-market rule. What the rule points to is that stock markets, just like many other markets, react negatively to interest-rate hikes by the U.S. Federal Reserve (the Fed) but positively when rates are lowered. The Fed is currently applying the brakes by raising rates. The yield on 10-year U.S. government bonds responded by rising to over 2.8%, and the S&P 500 then slumped by 8.5% in the first six trading days of February. Following this correction, many investors fear that further rises in interest rates could again put pressure on stock markets. But is this fear justified?
In theory it sounds plausible. John Burr Williams explained 80 years ago that the value of a share reflects the value of its discounted dividends. If interest rates rise, the present value of the dividends, which together make up the share's value, declines. If interest rates decline, the present value of the dividends – and therefore the share's value – increases. If both dividends and interest rates increase, because, for example, inflation is accelerating, this should generally have a neutral effect on the share's value.
So far so good. In practice, however, inflation, profits and dividends fluctuate and are hard to predict. This is due to the twists and turns of the economy. When there is pessimism about growth, profit expectations and interest rates usually decline, and stock markets fall. When there is optimism about growth, profit expectations and interest rates usually rise, and markets gain.
Markets have sometimes ignored the "don't fight the Fed" theory.
In the second half of the 1990s, the internet flourished – and so did fantasies about growth and profits. Stocks rose sharply. Even the rise in interest rates that began in June 1999 and ended in May 2000 did little to dampen investor enthusiasm – until March 2000. The sudden bursting of the dotcom bubble, followed by the terrorist attacks on September 11, 2001, sowed doubts about growth. The federal funds rate declined in 13 steps from 6.5% at the beginning of 2001 to 1% in June 2003. Declining interest rates should, in theory, have buoyed stocks. In practice, falling profit and dividend expectations more than offset the interest-rate decline – and stocks fell as a result.
During the economic downturn that followed the bursting of the dotcom bubble, investors were extremely pessimistic. In 2003, the optimists slowly regained the upper hand. Growth forecasts were upgraded, and bond yields increased. At the same time, rising profit and dividend expectations resulted in stock-market gains. The positive earnings effect offset the negative interest-rate effect.
The housing and financial crisis that began in 2007 also revealed the significance of profit expectations for stock markets. Returns fell to record lows due to deep pessimism about economic growth. Both the yield on conventional 10-year U.S. government bonds – which reflects expectations about nominal growth – and the yield on inflation-protected 10-year U.S. government bonds – which reflects expectations for real growth – declined. The decline in bond yields and the convergence of nominal and real yields showed that investors expected a significant weakening of the medium- to long-term growth trend and an end to inflation.
Indeed, prices increased at a much slower pace in the years following the onset of the crisis. In an environment without inflation, companies had little flexibility to pass on rising costs through prices. Sales also increasingly came under pressure during the crisis. Profits plunged. Lower medium-term inflation and growth expectations also contributed to a sharp drop in profit expectations. Stock values fell sharply during the recession that lasted from late 2007 until June 2009. Growth optimism then gradually returned. Forecasts for future profits rose, and share prices increased again.
Following the financial crisis, interest rates were cut and remained at rock bottom; following the dotcom crisis they gradually rose. In both cases, share prices increased. But what happens when bond yields increase rapidly and sharply? The events of 1999 provide a good example. At the time, high growth and inflation expectations led the Fed to sharply increase its benchmark rate, and bond yields soared. Yet, stock markets continued to rise strongly. The downturn didn't come until March 2000. Although "don't fight the Fed" eventually proved accurate, this maxim wasn't especially helpful in choosing the right time to buy or sell.
In summary, the current low bond yields indicate that only moderate growth is expected. The gap between conventional and inflation-protected bond yields has increased slightly since mid-2016 but remains small. Inflation expectations are trending upward but remain historically low. The Fed is therefore normalizing its monetary policy in small steps, resulting in a gradual interest-rate increase. History has shown that stock markets perform positively when only a modestly rising interest-rate environment is expected. We therefore retain our positive expectation for equities.
The yields on conventional and inflation-protected U.S. government bonds give indications of growth and inflation expectations.
Source: Thomson Reuters Datastream as of 3/3/18
From January 1991 to February 2018, the S&P 500 performed best when bond yields were rising moderately
* Calculation period between Jan. 1991 and Feb. 2018
Source: Thomson Reuters Datastream as of 3/3/2018
1. Quote from Martin Zweig's Winning on Wall Street. New York, 1986
2. John Burr Williams: The Theory of Investment Value. Amsterdam, 1938.
3. The quantitative-easing program of the U.S. Federal Reserve resulted in declining interest rates from late 2008 onward but meant that yields were a less meaningful expectation barometer for growth. In May 2013, the Fed announced a reduction in quantitative easing. In October 2014, the Fed ended this bond-purchase program.