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With concerns of inflation high, many analysts expect interest rates to rise or remain at elevated levels, as was the case in the '80s. However, the leading concern traders and investors have is the impact of rising rates, or elevated rates on the performance of stocks, i.e., the S&P 500, Nasdaq composite index, Wilshire 5000, other US stocks (not included in major indices), and derivative products such as ETFs like SPY, XLF, QQQ, etcetera.
This work examines the impact of rising interest rates and elevated rates on the performance of the S&P 500, stocks, and ETFs based on the broader market. Returns, risk, and risk-adjusted returns of equities in periods of rising/elevated rates are examined.
Figure 1. Discount rate movements
Primarily, the FED maneuvers discount rate to achieve its congressional mandate, which is to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."
Put simply, the FED manages the discount rates to influence the economy, i.e., it lowers rates in periods of reduced/depressed productivity & increases them when concerns of inflation/overheating of the economy are high, or the rate of inflation has risen beyond the acceptable long-term rate, which, ideally, the FED expects to be about 2%.
The FED maneuvers the 'FED funds rate' (the rate at which commercial banks can borrow and lend excess reserves), and the monetary transmission mechanism (the process through which asset prices and economic activity are influenced through monetary policy), to influence interest rates more broadly in the economy.
Lowering of rates, as done in response to the 2020 crisis period, is a move towards an expansionary monetary policy, characteristics of which are cheaper credit, increased money supply, and a dovish approach taken by the central bank; on the other hand, rising rates are the implementation of a hawkish view by the Fed, characterized by a tightening of the money supply & increased cost of credit; this approach is taken to control an overheating economy and inflation.
Conventional thinking/theories suggest that:
(1) As the overall discount rates rise, the valuation of stocks, as done through models that discount the cash flows produced by the companies, should fall (due to an increased cost of capital); however, if inflation doesn't impact the sales volume of the companies, the cash flows should rise—or maintain the long-term trend. And if this is the case, then the performance of equities should, in theory, have an initial downward move, followed by normalization, and then a rise, as the lower price (due to a higher cost of capital) with stable/increasing cashflows/earnings should make equities an attractive investment again.
This condition is likely to occur during future hawkish turns by the fed.
or,
(2) The contractionary monetary policy with a tightening of credit—and the ending of the impact of the 'free ride' of quantitative easing—may increase capital scarcity (funds/money, to put it simply), which may negatively impact aggregate spending, consumption, and investment spending in the economy; the impact of such a move, some argue, would be a significant reduction in valuations and multiples on stocks; whether such a scenario materializes through a significantly reduced growth rate of stock prices or a sharp downward move, equities should perform poorly.
Furthermore, it is argued that during periods of contractionary agenda/monetary policy, if aggregate demand in the economy declines, sales of firms and, subsequently, earnings and cash flows should fall, which would mean a twofold blow to equities &, possibly, result in a significantly adverse period.
The outcome that actually materializes in future hawkish periods, nonetheless, depends on the economy's fundamental strength and factors such as aggregate technological advancements, outlooks of economic agents, labor participation—given the conditions—and productivity rates of employed capital, etc.
It must be noted that projecting and forecasting all the variables involved in this area is very difficult, and models are error-prone, hence, usually unreliable.
This work, nevertheless, evaluates empirical evidence, i.e., examines what actually happened in previous such periods.
Empirical analysis
The impact of a hawkish approach and rising rates, per period, i.e., when such an approach was implemented, is summarized below:
Table 1. Performance of stocks per period(s) of rising rates (monthly)
Table 2. Long-term monthly performance of the S&P 500 (562 months time-series)
So, does a rise in interest rates affect stock prices and performance?
To test this assumption scientifically, hypothesis testing has been applied in this work. Performance of stocks per periods of rising rates is compared with the long-term performance of the market (S&P 500).
The results
Hypothesis testing confirms that rising interest rates and periods of elevated rates, which can also be classified as periods of hawkish or contractionary monetary policy, have not had any statistically significant impact on the weighted average & average returns of the US stocks/S&P 500 in such periods [1] (results of statistical tests included at the end of the report).
Secondly, the risk, as measured by standard deviation, of the two compared doesn't hold any statistically significant difference; put simply, the risk of S&P 500/stocks (as measured through volatility: standard deviation) in Hawkish periods is statistically identical to the long-term risk profile of the market [2].
Similarly, the value at risk (VaR) of the two compared periods does not demonstrate any significant difference.
Another key factor that—on the face of it—does differ between the two periods considerably is the risk-adjusted returns—Sharpe ratio.
When a simple average is calculated, the risk-adjusted returns &, hence, the Sharpe ratio of periods of rising/elevated rates yields a figure -115.6% lower than the long-term average Sharpe ratio of the market.
If a simple understanding is applied, one may assume/interpret that:
Net returns that the market offers in periods when rates are high, i.e., the returns of the market minus the risk-free rate, when assessed in relation to the risk of holding the market/stocks in the portfolio (measured through volatility), is considerably lower in periods hawkish policy is implemented; put simply, during such periods, investors earn returns that are similar to the long-term average returns, the volatility/risk of stocks is also the same, however, as the risk-free rate is elevated, the risk-adjusted returns are lower than the long term figure.
However, the above stated line of reasoning isn't thorough; when the long-term Sharpe ratio is weighed by period-specific values, i.e., out of 200 months, this ratio for a 20-month period is weighed by 10% (weighted mean is calculated), the Sharpe ratio matches the long-term ratio, only exhibiting a marginal difference, (7.1% compared to 7.7% long-term Sharpe ratio).
Critical investing/trading takeaways
Alarmism and overreaction to concerns are, as we all know, very high in financial markets; the subject analyzed in this work increases the perception of uncertainty in the minds of investors, as theoretical viewpoints allow for a sharp downward move in the markets in response to a rise in interest rates by central banks. However, these theoretical viewpoints have been tested in this work scientifically, and the results should dispel all irrational apprehensions in the minds of investors and traders.
The results confirm that a rise in interest rates by the central bank (FED)—overall—has not had any statistically significant impact on market returns, risk/volatility, and risk-adjusted returns over such periods in the last half-century.
During future hawkish periods, as policies and outlooks are changed by the FED, we should expect short-term fluctuations in the market; however, as per empirical evidence, we shouldn't expect long-term returns & risk of investing in stocks to be impacted in any meaningful manner.
Of course, returns/risk in specific future periods may differ; nonetheless, long term, we should expect the market/stocks to yield returns comparable to the long-term average of the market.
There is one more factor of significance that investors should understand: the principle of reversion to mean (asset returns and risk, over time, should revert to long-term average).
This factor is important under the current subject, as during periods of overheating, i.e., high overall economic demand and unsustainable rise in inflation, i.e., conditions that act as a catalyst for a hawkish turn by central banks, markets can move more towards a bubble state (a state when asset prices are irrationally high).
During such periods, asset returns can rise considerably (as seen during the 2020-2021 period). However, when a turn towards a hawkish policy is made, and sentiment/outlooks change, a sharp downward move can occur; such a move can also be classified as a move towards reversion to mean.
Nevertheless, while reversion to mean is a logical expectation & one that is very likely to hold in future periods, if such downward/stagnating pressure on prices occurs during a period of hawkish agenda by the FED, the rise in rate may inaccurately be criticized as the cause of the downward pressure/adverse period for assets. The analysis in this work, however, suggests that if such attribution error is made, empirical evidence won't support it.
Put simply, when assets rise at rates substantially higher than their long-term average growth rate, it is rational to expect that the price wouldn't rise at the same pace in subsequent periods and, as evidence suggests, should experience a lower or negative growth rate till such rate is more in line with the long-term average.
Thus, if the FED raises rates, after a period of considerably higher growth rates of asset prices (as experienced during 2020-2021), and the market crashes or experiences a bearish period, the rise in rates may not be the cause for such an adverse period. The decline, more accurately, would be the principal of reversion to the mean in action.
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