Interest rates staying higher for longer doesn’t doom stocks, and here’s the proof

Market bears think investors bought stocks when interest rates were too low to generate returns and therefore the inverse must also be true. But yields have never ruled stocks.

Reserve Bank governor Michele Bullock. Picture: Bloomberg

Will high interest rates kill stocks?

Last month 10-year Australian government bond yields (AGBs) and 10-year US Treasurys brushed 5 per cent – the highest in over a decade. This squished spreads between bond payouts and stocks’ “earnings yields” (the price-to-earnings ratio’s inverse, or firm’s annual earnings as a return or “yield” on current share prices).

Most think this eliminates stocks’ allure. Bears claim puny interest rates turbocharged stocks’ last decade. TINA – there is no alternative – became their mantra, claiming investors bought stocks only because interest rates were so low. Now they say “higher for longer” rates doom stocks. Wrong. Counter to conventional wisdom, yields don’t rule stocks. Never have. Here is proof.

Saying higher rates stymie stocks presumes these two fight over some singular money pile. Allegedly, stocks’ earnings yields must nicely exceed long-term, “risk-free” government bond yields to justify stocks’ higher volatility.

When the Reserve Bank started hiking interest rates in May 2022, the ASX 200’s forward earnings yield topped AGB yields by over 3.1 percentage points. Now it is just 1.9 percentage points. The spread between America’s tech laden and pricier S&P 500 and 10-year Treasury yields is under 1 percentage point. “Too puny to justify stocks’ volatility”, bears bellow.

That is simply theory. In reality, inflation-adjusted earnings grow with the economy. Inflation boosts earnings in dollars. Business cycle volatility and sentiment swings skew valuations around market lows and early in young bull markets – as seen since global stocks’ 2022 swoon ended.

Why? Stocks look forward. Reported earnings look backward. When recent stock returns and sentiment stink, analysts’ earnings projections routinely fall. Early bull markets bring a lower “e” and higher “p,” depressing earnings yields. Like now. Always have.

Hence, yield spreads hold only irregular predictive power. Consider: Much narrower gaps haven’t stopped stocks. During the 2003–07 bull market, the ASX’s forward earnings yield averaged just 1.75 percentage points above AGB yields. Yet Australian stocks boomed 207 per cent over that stretch.

From 1996 through 1999, US stocks’ average forward earnings yield was -0.33 percentage points below average 10-year Treasury yields. US stocks didn’t slump – they soared 155 per cent in US dollars.

High absolute bond yields don’t kill stocks, either. Take the 1980s. That decade, 10-year AGB yields averaged 13.4 per cent … yet Aussie stocks skyrocketed 409 per cent. In the 1990s, 10-year Australian yields averaged 8.5 per cent. Stocks rose another 185 per cent. America’s 10-year Treasury yields averaged a lofty 10.6 per cent in the 1980s and 6.7 per cent in the 1990s, never under 4 per cent. Yet US stocks still jumped 400 per cent in the 1980s and 433 per cent in the 1990s in US dollars.

Why don’t high “safe” yields sink stocks?

Unlike bonds held to maturity, stock returns aren’t capped by coupon rates. They benefit from potentially limitless economic growth and, more so, innovation. If management foresees earnings growth, it can borrow and repurchase shares, shrinking their supply but boosting earnings per share. Bonds can’t do any of that. And, if long rates rise further, existing bond prices fall, too – squashing bond returns – like in 2022.

Bond yields reflect inflation expectations. Higher yields signal elevated inflation, reducing bonds’ future value. But firms eventually pass on costs. So, long term, stocks weather inflation better.

Yes, global stocks sank as 2022’s inflation ignited. But that was mostly sentiment.

Consider: global firms’ gross profit margins as 2023 started were 35.6 per cent – minutely below year-end 2021’s 37.2 per cent. Resource-heavy Australia saw margins actually rise alongside commodity prices. Plus, bond prices’ 2022 plunge largely paralleled stocks in timing and magnitude.

Regardless, ebbing global inflation now signals yields’ past increase won’t endure – even in Australia, the third quarter’s much ballyhooed inflation uptick notwithstanding.

As Milton Friedman famously said, inflation is always and everywhere a monetary phenomenon.

Australian M3 money supply grew just 5.0 per cent year-over-year in September. US M4, America’s broadest money measure, fell throughout 2023. Both are far below the Covid-era double-digit growth spiral that turbocharged inflation. It portends more cooling.

Might new Reserve Bank governor Michele Bullock keep hiking? Maybe! Maybe the US Federal Reserve reverses its “pause”. But while 2022’s initial hikes shocked stocks, surprise power is now kaput. Fact: the ASX is actually up since hikes started. Ditto for America’s S&P 500.

Earnings yield comparisons can be useful – for example, assessing when company borrowing to fund stock buybacks makes sense. But rates don’t dictate stocks’ direction. Never have.

The correlation between the ASX and 10-year AGB yields is only 0.14, indicating a tiny tendency for stocks and yields to actually rise and fall together – but hardly significant, given 1.00 is lock-step movement and -1.00 is the polar opposite. Same for US stocks and 10-year Treasurys’ 0.26 correlation.

So cheer the bogus bond yield bogeyman. False fears only add to the legendary “wall of worry” that propels bull markets higher.

Ken Fisher is the executive chairman of Fisher Investments