Two weeks ago, an outsized wage number scared enough investors to provoke a long awaited surge in volatility. Last Wednesday, an even bigger upside surprise in actual inflation also spooked investors… for about an hour. Following a brief selloff, markets rallied, despite U.S. Treasury yields hitting a four-year high. While the yield on the 10-year Treasury eclipsed 2.9%, up nearly 100 basis points (bps, or 1%) from the September low, the S&P 500 gained more than 1.3% and the NASDAQ nearly 2%. What accounts for these wildly different reactions?
The short answer is that after the initial shock, investors appear to have decided that they can live with higher yields, at least higher yields that are a function of a strengthening economy. Nor is this particularly unusual. Contrary to conventional wisdom, it is not unprecedented for equity markets to rise along with interest rates. In fact, when rates are rising from exceptionally low levels, it is normal for rates and stock valuations to move together.
Why? Here are three things to remember:
1. Negative correlation
Financial theory does suggest that equity valuations, i.e. the price you pay for a dollar of earnings, should drop as the interest rate used to discount that earning rises. Empirical evidence supports this. A simple linear regression of stock multiples versus interest rates demonstrates that over the very long term, rates and market multiples are negatively correlated. Since 1954, for every one percentage point increase in 10-year Treasury yields the price-to-earnings ratio (P/E) on the S&P 500 contracts by approximately 0.70 points.
2. Nonlinear relationship
However, if you allow for a more complex expression of the relationship, things look somewhat different. Rather than a straight line, a better description of the relationship between rates and multiples is nonlinear, i.e. the relationship changes depending on the level of rates. Allowing for this nuance, interest rates explain nearly 30% of the variation in S&P 500 earnings multiples (see the accompanying chart).
3. Low interest rate levels
Rates and multiples are more likely to rise in tandem when interest rates are rising from unusually low levels, as is the case today. Under these circumstances, faster growth is treated as a positive as it alleviates recession and deflation fears. In addition, faster nominal growth is also associated with faster earnings growth.
Unfortunately, there is a caveat. Rates and valuations can rise together—to a point. At some point the negative relationship between rates and valuations reasserts itself. In other words, at a certain level higher bond yields create real competition for stocks, particularly dividend stocks, and put downward pressure on multiples.
Based on Wednesday’s market action we’re clearly not at that point yet. That said, if bond yields were to climb substantially, let’s say towards 4%, history suggests that the negative relationship between bond yields and equity valuations will begin to reassert itself. I would be particularly concerned as higher rates would be rising against a backdrop of an older population with a taste for income and elevated debt levels. But for now, higher rates and higher stock prices can probably co-exist.