How Higher Rates Negatively Affect Equities:
- Reduced value of future earnings. In its purest form, equity prices reflect the discounted future earnings of a company. Higher interest rates increase the discount rate, thereby lowering the company’s present value. If rising interest rates aren’t offset with higher top-line growth, either through higher prices (inflation) or higher volume (more demand), then equities could be in trouble as market participants price in a higher discount rate.
- Declining attractiveness of equities as earnings yields decline. When earnings yields significantly exceed bond yields, it becomes cheaper for companies to finance projects, M&A, and share repurchase programs. When the difference between earnings yields and bond yields is zero or negative, the equity-market boosting behaviors could slow or stop. With increasing bond yields and high stock valuations, that gap has been decreasing, but it still remains at above-average levels. So while it’s not a red flag yet, if the gap continues to narrow, it could drive stock prices lower.
An ETF Toolkit in a Rising Rate Environment
A rising rate environment does not signal immediate danger for the economy, since the private sector has deleveraged a great deal since the crisis and the Fed has been very methodical in communicating future rate hikes. However, markets are forward-looking and investors could start to price in the effect of higher interest rates on financial assets before they actually materialize.
It’s important for investors to have options in order to prepare for that scenario. Within equities, XLF (Financial Select Sector SPDR Fund) provides exposure to a sector that stands to outperform as financial services companies, such as banks and insurance companies, have historically shown higher profitability during periods of higher interest rates. Within fixed income, exposure to inflation-linked bonds through TIP (iShares TIPS Bond ETF) would shield bond investors from rising interest rates, due to rising inflation expectations and/or rising commodity prices. The Senior Loan Market provides investors with exposure to corporate debt without the corresponding interest rate risk; we prefer the actively managed version through SRLN (SPDR Blackstone / GSO Senior Loan ETF).