Equity investors are wary of increasing interest rates as the Federal Reserve is persistent in raising yields in 2018. Although increasing the rate might put pressure on equity prices, the market has largely been indifferent to increasing rates until now. This might, however, change when interest rates cross a certain threshold.
I recently wrote about the indifference of the current stock market to the rising interest rate environment. Although higher interest rates should translate into lower equity prices, the market has been irresponsive to interest rate hikes and the rollback of quantitative easing polices, also termed as the hawkish stance of the Fed.
As I argued before, the minimal response of the market to changes in policy might be due to the delay in the transmission of policy measures to the balance sheets of financial intuitions, or there might be a threshold interest rate that has to be crossed before the market moves toward fixed-income assets, consequently weighing on the stock market.
What is the reference point for what that threshold interest rate might be? Put simply, what short-term interest rate would tempt investors to move their money away from the stock market? Well, Goldman Sachs (GS, Financial) believes they might have the answer.
According to Goldman's chief U.S. equity strategist, David Kostin, equity investors are safe unless the 10-year Treasury yields hit 4%. In a note to clients, he wrote: “We expect negative valuation changes if the level of rate approach 4%.”
Kostin also thinks there might be a possibility of negative price action in the stock market before the interest rate hits the given threshold if the rate rises too quickly. As of last Monday, the 10-year Treasury yield reached 3.11% – its highest level since 2011 – before retreating to 3.06% by the end of the week, well below the threshold cited by Goldman Sachs.
Kostin’s comments were rather subjective without any substantive evidence to support the threshold claim. Whether he didn’t have the backing or he chose to hold it back is unknown. One thing is clear, however; rising rates will take a toll on the stock market at some point in the future. As rates continue to rise, the reward-risk ratio (also known as the Sharpe ratio) will tilt in favor of fixed-income assets, initiating the outflow of funds from the equity market.
Although the threshold provided by Goldman Sachs might not prove to be accurate in retrospect, it does alert investors to the dangers of an overweight stock market investment in a rising rate environment.
What does it mean for investors?
For starters, index investing might not be the way to go. If Goldman Sachs is right about the threshold, funds will move toward fixed-income assets, which will adversely affect index returns. A good strategy would be to look for reasonable growth companies with a history of consistent earnings, and use discounted valuations as reference point for long-term investments. This is because increasing rates are negatively related to present value of earnings and, consequently, to the valuation of a given company.
The bottom line is, threshold or not, rising interest rates do not bode well for equity investors, especially index invesotrs. If you have to be in equity, value investing should be the go-to approach in the rising interest rate environment.
