The Big Picture
Last Updated: 18-Aug-23 06:48 ET | Archive
Striking better balance with interest rate shift
Interest rates are rising. That is not a new revelation, and it should not be a shock to anyone who has been watching the market for the past few years.
The increase in rates has occurred in response to rising inflation, which has necessitated higher policy rates. Again, not a shock to anyone who has been watching the market for the past few years.
What may be a shock to anyone who has been watching the market only the past few years is that interest rates aren't as bad as they look. It is the pace at which they have risen that has made them feel bad, but the level of rates themselves is, well, closer to normal before things became abnormal during the 2008 financial crisis.
Tables Have Turned
All else equal, lower interest rates are better for stocks than higher interest rates, but higher interest rates aren't necessarily a death knell for stocks, particularly if they are driven by stronger than expected economic activity that is good for corporate profit growth.
Higher interest rates, however, create more competition for stocks. They lower the present value of future cash flows and raise the appeal of parking capital in less risky investments like money market funds, highly rated corporate bonds, certificates of deposit, and risk-free Treasuries.
That is why when interest rates were languishing at such low levels during the abnormal, post-2008 period, which got even more abnormal with the COVID response, one often heard the refrain that "there is no alternative" to stocks. That refrain was dubbed "TINA."
Because market rates and policy rates were so low, savings rates offered by financial institutions were a joke, certificate of deposit rates and money market rates were unappealing, and corporate bond yields forced investors down the quality ladder to get a decent return.
The tables, though, have turned.
Spreadin' the News
You can find yields north of 5.00% in the Treasury market, in higher-quality corporate bonds, in CDs, in money market funds, and even in some savings accounts.
Of course, that still pales in comparison to the S&P 500, which is up 13.8% for the year as of this writing. Anyone watching the stock market this year, though, knows that return has been cooked so to speak by the outsized gains in a small group of mega-cap stocks. The Invesco S&P 500 Equal-Weight ETF (RSP) is up 4.1% for the year with a higher risk profile than the yield vehicles noted above.
We have made the point in the past, however, that a gain... is a gain... is a gain in the market-cap weighted S&P 500. They aren't going to discount you at the door when you sell the S&P 500 just because its outperformance has been juiced by a small group of stocks.
The latter point notwithstanding, one assumes a higher risk of capital loss in stocks, so an investment decision between stocks and other instruments boils down to one's risk tolerance over a specified time horizon. The problem in the abnormal past is that it was a struggle to get real returns in anything other than stocks.
That is no longer the case.
What we see today, too, is that the trailing twelve-month earnings yield for the S&P 500 (4.95%) is less than 70 basis points higher than the yield on the risk-free 10-yr note (4.30%) and is comparable to the yield on the 2-yr note.
The translation is that equity investors aren't necessarily getting compensated as generously as in the past for taking the added risk of owning stocks. In the abnormal period between 2008 and early 2020, the earnings yield spread over the 10-yr note ranged from 160 to 700 basis points.
What It All Means
It is pretty clear to anyone watching the stock market this year that it has defied most people's expectations. As we discussed last week, the big run through July has given way to a consolidation period in August, and the bid to trim positions has been encouraged by the jump in long-term rates seen this month.
That is creating competition for stocks, and dare we say, a more normal opportunity for income-oriented investors and investors with a lower risk tolerance.
Importantly for the investor class, it creates an opportunity to strike a better balance and to lower risk in investment portfolios. That's not a bad thing. Some might even call it a return to normalcy after an extended period of abnormally low interest rates.
-- Patrick J. O'Hare, Briefing.com
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