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From our CIO | Market Update 1.17.18

by: Rick Wedell
published: January, 17th 2018


There’s been some interesting conversations in the press recently around interest rates and stock market valuations, including an op ed by Martin Feldstein in the WSJ this morning, and I thought it was worth a quick comment to explain what is going on.

We’ve seen some pressure on US Treasuries recently and that pressure is expected to continue.  The 10 year is currently at 2.55%, up roughly 15 basis points for the year, since touching a low close to 2.05% in early September of last year.  The drivers of the rise in treasury yields include 1) continued robust economic growth expectations, 2) increased budget deficits domestically (something which the tax plan is helping to fuel), and 3) rising European and Japanese interest rates.  The first two are self-explanatory (interest rates rise with expanded growth and with increased borrowing), but the third is worth visiting briefly.  The US has perhaps the highest borrowing “cost” of any developed nation, and it’s not really all that close – as of year-end Germany’s 10 year yields were 30 basis points, Japan’s were 3 basis points, and even Italy and Spain are roughly 80-100bps below our 10 year rate (which is ironic because both of those countries were literally on the verge of collapse in recent memory).  This is due, at least in part, to efforts by the central banks in those nations to continue to constrain interest rates in an effort to stimulate their economies.  The lower yields in other developed countries create artificial pressure on our 10 year yields, since normal buyers of sovereign debt may prefer to get a higher yield on US paper than by investing in these other nations.  While here at home the Fed has been pretty clear about their desire to raise interest rates, a move higher in foreign yields (driven partly by a view that foreign central banks are willing to let interest rates rise) is a relatively recent phenomenon which is creating additional pressure on Treasuries. 

So here’s where the fun part comes in.

Classical market theory would tell you that interest rates rise in response to economic growth, and stock prices rise as earnings grow, so stock prices should rise when treasuries fall (and vice versa).  However, there is currently a debate about the risks to the market if interest rates rise too rapidly.  Rapidly rising interest rates may create pressure on stock market prices for a couple of reasons.  First, there is a pure substitution effect from equities into bonds as bonds become more attractive from a yield standpoint – investors may seek to transition more of their portfolio into fixed income if yields are higher.  Second, there is a valuation effect – stock prices are generally viewed as a discounted cash flow of the earnings these equities are supposed to earn which requires you to use a discount rate to determine the multiple.  If this discount rate rises, then multiples should fall.  Last, but not least, there is also likely an “economic brake” effect, since on the margin higher interest rates act as a brake on economic growth, which may cause investors to trim down their earnings expectations for 2018 and beyond.

A lot of this debate will boil down to the magnitude and timing of a rate increase.  If rates continue to gradually climb higher through the year and end somewhere close to 3% on the 10 year, the equity market likely shrugs it off.  If rates spike suddenly, we are more likely to see a valuation driven correction in equities.  While these types of valuation driven sell offs are usually shallow and short lived, it may be painful since equity and bond prices will correlate.

 

Rick Wedell is not affiliated with LPL Financial.

One basis point is equal to 1/100th of 1%, or 0.01%.

Investment advice offered through RFG Advisory Group, LLC, a Registered Investment Advisor.

The economic forecasts set forth in this material may not develop as predicted. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.