Submitted by Lance Roberts of STA Wealth Management,
There is a rising belief that when the Federal Reserve begins to taper that interest rates are set to rise. It is believed that as rates rise due to stronger economic strength that the stock market will act as a hedge against falling bond prices. Recently, Blackrock attempted to answer this question by stating:
“Most investors fear rising interest rates. But perhaps more than the others, bond investors fear the loss of portfolio value that may occur when interest rates rise. Which begs the question – are there alternatives to bonds that might offer income and behave better in a rising rate environment? Indeed, global dividend stocks offer a compelling potential of income and outperformance in rising rate environments.”
It is important to understand the underlying dynamic at play here which is that as interest rates rise – stocks will rise in price offsetting the decline in bond prices. The chart below from Blackrock attempts to prove their case by showing a comparison between stocks and bonds.
However, is that really the story? The problem with the data is that it is very selective in its construction. What the chart doesn’t discuss is what happened next.
The chart below shows the 10-treasury rate from 1957 to present versus the S&P 500. I have also noted with vertical dashed lines, the peaks in interest rate increases along with major economic events and recessions. (Note: I have also noted the two relative market patterns of the current and previous secular bear markets.)
If you look at the chart closely a much different picture emerges from Blackrock’s analysis. As you will notice in almost all cases when interest rates rose sharply there was either a subsequent economic shock, recession and/or fairly significant market decline.
In order to more clearly show the analysis I constructed the following table which lists the start and end date of significant interest rate increases and the subsequent market selloffs.
Importantly, historically speaking the market has tended to have corrections in conjunction with rising rates as the economy was negatively impacted. However, during the most recent history the negative impact was delayed by market momentum and liquidity driven booms. Eventually, the market and economy, in all previous cases, has given way to the impact of higher rates.
The current rise in rates is the second largest in history on a percentage basis at 83.66% versus 85.59% during the 1976-80 period. That previous spike in rates led to a 15% decline in the market in the middle of that spike.
The recent rise in rates has already started to negatively impact the housing market and most likely the economy as we see deflationary pressures rising. However, as I have recently discussed in “3 Myths About Rising Interest Rates:”
“The first misconception is that when the Fed tapers its ongoing liquidity program; interest rates will begin to rise. However, there is no anecdotal evidence that would be the case as shown in the chart below.”
“In fact, the recent rise in interest rates should have been anticipated as that has been the case during both previous programs. It was not until the programs began to ‘taper,’ and eventually end, that rates fell as money flowed out of risk assets in search of safety in the bond market. This fall in rates also corresponded to economic weakness and expectations of an increase in deflationary pressures.
When the Fed once again begins to remove its accommodative support from the financial markets it will likely lead to a further decline in interest rates as ‘safety’ is once again sought over ‘risk.'”
Will stocks offer protection from rising interest rates? Historically speaking rotating from bonds to stocks AFTER the spike in rates has occurred was akin to jumping from the “frying pan into the fire.”