When the Federal Reserve raised rates in 1994, the stock
market endured little more than a glancing blow. When the rate cycle eventually
turns this time around, investors may not be so lucky. With the job market
looking stronger, economists have been moving up their estimates for when the
Fed will begin raising its target range for overnight rates. In The Wall Street
Journal's August economic forecasting survey, 75% of respondents said they expect
the Fed to tighten by the first half of next year, up from 56.5% who thought so
in May.
For anyone trying to gauge how rate increases might affect
markets, 1994 offers a natural analog. Back then, investors had become
accustomed to low rates—it had been five years since the Fed had tightened
policy—and so were caught offsides when the central bank made its move. But
while bonds got trounced, the damage to the stock market was short-lived. At
its worst point, the S&P 500 was down all of 5.9% from the start of that
year, but it finished out 1994 with a loss of just 1.5%. And with dividends
reinvested, it posted a gain of 1.3%.
But an important consideration is how much lower interest
rates are now, and how those low rates have led investors and companies to
behave.
The yield on the 10-year Treasury note at the start of 1994,
at 5.8%, was about 3.2 percentage points above the rate of inflation. The
current yield of 2.4% is just 0.3 percentage points higher than inflation. That
creates a stark calculus for anybody trying to generate income in the bond
market.
Some have converted into REITs or unloaded assets into
master limited partnerships. Many have boosted cash returned to shareholders
through dividends and buybacks. At nonfinancial companies, the past 12 months'
dividends and net share repurchases came to
4.2% of market capitalization at the end of the first quarter, according to the
Federal Reserve
If stocks are more bond-like than they were heading into
1994, the risk is that they will have a more bond-like reaction to rising
rates, and fall. Adding to the risk, valuations may not be as supportive.
The S&P 500 now trades at about 17.3 times the past
year's earnings, a little bit lower than the 18.3 price/earnings multiple it
had heading into 1994. An important difference is that in 1994 profits
accelerated, with S&P 500 earnings increasing by 18%. Such a gain seems
unlikely now, when profit margins are at record highs and labor and equipment
costs are primed to rise. Analysts expect S&P 500 earnings to grow by 12%
next year, according to Thomson Reuters I/B/E/S.
One reason investors have been willing to pay so much may be
that they see low rates as a justification for receiving lower future cash
flows on their stock purchases. But if rates increase, that justification gets
swept away.
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