Concerns about interest rates exaggerated – little risk of a bear market in equities

Summary:

  • Concern about rising inflation resulting in higher capital market yields has returned
  • An increase in key interest rates does not mean that the markets are collapsing; in historical terms, stock markets have continued to show a slight upward trend
  • There is currently too much focus on concerns about interest rates – attention should soon switch back to the dynamic trend in profits

Do you remember? – Exactly one year ago, the markets were driven by the issue of “reflation”, a return to inflation triggered by a more expansionary approach to monetary and fiscal policy and rising commodity prices. At the time, inflation in the USA rose to 2.5%, the highest level since 2012. Concern about rising inflation resulting in higher capital market yields has now returned, driven this time by fears that wages will rise more rapidly. We consider it unlikely that an inflationary surge of this kind will take place in the medium term. However, the unemployment rate in the USA has fallen to 4.1%, close to its lowest point in the last 60 years. Since so few employment opportunities remain, it seems quite conceivable that short term economic growth will lead to higher wages and consequently a further uptick in consumer demand.

The fact that inflation is still low despite the strong upturn, is attributable to the (still) modest trend in U.S. wages but also to the fact that we live in an era that is shaped by the effects of globalisation and rapid technological progress. These factors work against inflation. In addition, commodity prices are still at a relatively low level. Should, however, the crude oil price, which currently is around USD 60, and the prices of other commodities firm sharply, the Fed’s upper inflation target could be reached rapidly. In such a situation the U.S. central bank would have no other choice but to raise interest rates, which would impact accordingly on companies and stock markets.

Rising inflation may be good for companies as it encourages a certain growth in sales, but high inflation can also decimate profits through higher input costs. Inflation is only likely – in theory – not to affect corporate profit margins if companies can easily add higher costs to sales prices in an inflationary environment. This is usually only the case if inflation occurs during economic upturns. Otherwise – and particularly during a recession – profit margins will generally fall, since costs, especially wages and salaries, rise more rapidly and sooner than sales prices. Viewed empirically, equities have coped very well with moderate inflation.

Rising interest rates lead to companies being worth less in equities analysts’ conventional valuation models, because their future profits are discounted at a higher rate of interest. However, this effect may be mitigated by higher sales revenues resulting from rising prices (inflation). Rising interest rates also increase competition between the asset classes equities and bonds. In the third mechanism of action, rising interest rates affect the loan interest, which companies must pay on their debts, meaning that the costs of interest increase.

If central banks raise interest rates too far, there is a risk that central banks will stall the economic upturn and sentiment or the profit trend “per share” will turn completely. This was apparent in 2000 and 2007. However, for the time being we can still relax. Looking at the past, it is clear that stock markets are prone to periods of weakness starting from a U.S. yield level of around 4-5% – in this cycle perhaps at a far lower level already. However, we are not expecting such a marked surge in yields at this point.

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