With the US economy showing signs of life, the Federal Reserve is widely expected to raise interest rates during 2015 for the first time since the financial crisis.
And the market seems to be terrified by the prospect of higher rates. The Fed’s easy money policies have propelled the market higher for much of the past six years, and investors are concerned that if the market loses this support, a correction will follow soon after.
However, there’s plenty of evidence that suggest the opposite will happen.
Interest rate hikes – Three studies
The first set of data comes from Ben Carlson, a portfolio manager for the endowment fund at the Van Andel Institute, a medical research center in Grand Rapids, Mich. This data was first published in The Wall Street Journal.
Carlson looked at the 14 periods during which the Fed was boosting short-term interest rates since the S&P 500 index’s inception during 1957. It was found that the average return during each period was 9.6%, including dividends.
Another study, this time from Northern Trust, a Chicago-based firm, once again published in the The Wall Street Journal, measured stock performance from six months before to six months after the Fed’s first announcement of a rate hike. 80% of the time, the market moved higher following an announcement.
And finally, a short study from J.P. Morgan Asset Management. JPM’s study showed that during the past two-and-a-half decades, when the Fed increased interest rates by 0.25% stocks fell slightly soon after but rebounded within a one to three months.
The most interesting and comprehensive data set on the topic comes from Credit Suisse Group AG (ADR) (NYSE:CS).
Interest rate hikes – Broad study
Credit Suisse’s Credit Suisse Global Investment Returns Yearbook 2013, an annual publication and highly recommended read, looked at the data from a study conducted by Elroy Dimson, a respected Professor and expert in market history and theory.
Elroy Dimson and his colleagues looked at the data for 20 different countries over a period of 113 years to see if there was any relation between higher interest rates and higher real equity returns. Within the period studied, there were 108 overlapping 5-year periods, giving a total of 2,160 observations — so the conclusions drawn from this data can be considered to be highly informative.
The 108 overlapping five-year periods were ranked from lowest to highest real interest rates and allocated into eight bands; the lowest 5% and highest 5% of real interest rates with six bands of 15% in between. As the chart below shows, the difference in returns across the data set is significant.
The real interest boundary plot show the boundary between bands. The bars are the average real returns on bonds and equities, included reinvested income over the subsequent five years within each band. A the investment yearbook notes:
“…the first pair of bars shows that, during years in which a country experienced a real interest rate below ?11%, the average annualized real return over the next five years was ?1.2% for equities and ?6.8% for bonds…As one would expect, there is a clear relationship between the current real interest rate and subsequent real returns for both equities and bonds. Regression analysis of real interest rates on real equity and bond returns confirms this, yielding highly significant coefficients.”
The highest band, when real interest rates averaged 9.6%, equity returns over the subsequent five-year period hit an annualized 11.3%. This is significantly above the mean annualized real return of the US equity market during the period 1900 to 2014. Over this period equities produced an average annualized real return of 6.5%; bonds produced a return of 2.0% and bills produced 0.9%.
Interest rate hikes – Reduced risk premium
By definition, the expected equity return is the expected risk-free rate plus the required equity risk premium, where the latter is the key unknown. Credit Suisse’s data shows that up until a decade ago, it was widely believed that the equity premium relative to bills was over 6.2%. It’s now believed that the equity risk premium is significantly lower. In the US at least during the period 1900 to 2014, according to the data above, the equity risk premium versus bills was 0.6% lower at 5.6%.
However, as Credit Suisse points out, as the US has been the world’s economic powerhouse over the past century, equity returns are bound to be higher than average. Excluding the US, the annualized historical equity risk premium versus bills stands at a lowly 3.5%. Including the US the global premium over bills stands at 4.1%.
Still, not all markets are created equal.
|Market||Equity risk premium vs. bills||Equity risk premium vs. bonds|
Annualized equity risk premium 1900 to 2014.
Interest rate hikes: No need to fear a hike
All in all, the evidence suggests that investors have no need to fear an interest rate hike. The data suggests that while the market may suffer in the days and weeks following a hike, one to six months out, performance will start to improve and the market will push higher at a high single/double-digit clip.
Although, I should note that as always, past performance is not necessarily a guide to future performance.