Equity markets and interest rates in the US

February 2nd, 2018 by Brian Kantor

Equity markets and interest rates in the US – will we avoid inflation surprises?

The equity markets in the US have had an outstanding run. The S&P 500 is up 26% since January 2017 and has advanced with unusually low volatility. Day to day movements in the Index have been very limited by the standards of the past. The fundamentals of the market have been supportive of higher valuations. High operating margins and rising earnings, with upward revisions of earnings to come, combined with still low interest rates, have attracted these higher valuations. The future of earnings and margins has been further enhanced by the income tax cuts for corporates, small businesses and individuals. The animal spirits of corporate leaders are stirring, promising a boost to the economy from a strong pick up in capital expenditure.

The concern is that unexpectedly higher interest rates can offset these benefits, as earnings are discounted to estimate present values. As we show below, US Treasury bond market yields have been rising this year – but from abnormally low levels. Nominal yields for 10-year money have increased this year from 2.45% to current levels of 2.72%. So have real yields – they have risen from a very low half a per cent in early 2018 to over 0.6% now. Furthermore, the gap between nominal and real inflation protected interest rates has increased from 2.45% at the start of 2018 to the current level of over 2.7%. This spread reveals the inflation rate predicted by the bond market. The bond market is anticipating and being compensated for slightly more inflation expected over the next 10 years.

The Fed’s target for inflation is 2% – a target that it is still to meet and is by no means certain of meeting any time soon. The Federal Open Market Committee, reporting this week (31 January 2018) still expects inflation to stabilise around its 2% objective over the medium term in its latest statement. It also repeated its view “that near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely…”

The most supportive scenario for the equity market will be one of rising real interest rates – indicating stronger growth in demands for capital – coupled with still very subdued expected inflation that will sustain low nominal interest rates. It is not higher real interest rates that represent danger to equity valuations. It is more inflation expected that would drive nominal interest rates higher that represent the threat to equity markets. Not only the Fed, but the markets, will be watching inflation developments closely. They will also be watching each other closely to avoid inflation surprises. Equity investors must hope that inflation does not surprise on the high side. Low inflation and strong real growth are what equity markets will thrive on, as they have done lately. 2 February 2018