Rising rates do not dictate stock prices

All signs point toward March for the first increase to the Federal Reserve's key interest rates that have been near zero for the last two years.

Annual inflation above 7% — the highest in 40 years — and exceptionally strong employment data make a policy change inevitable.

Now that rising interest rates are upon us, what can investors expect from their portfolio?

Even though interest rates and bond yields have fallen steadily since the early 1980s, there have been several years in which the Fed has hiked its benchmark rate. Since 1981, we have seen 18 calendar years with at least one increase. With consensus expectations on Wall Street projecting five rate hikes in 2022, we will focus on the 11 years that brought at least three Fed hikes.

The S&P 500 was positive in eight of those 11 years and had an average return of 5.7%. For the four years in that span with five or more rate hikes, the S&P was positive in all but one (1994) with an average return of 3.1%.

This back-of-the-napkin analysis suggests two things: Rising interest rates by no means coincide with losses for equities, and a higher frequency of rate hikes in a single year is only marginally worse for stocks.

It's been a popular suggestion that the U.S. may be embarking on a period of hyperinflation last seen in the 1970s. Let's assume for a moment this proves correct. In the nine years from 1971 to 1980, the Fed raised rates at least four times in every year except one.

As you can tell by now, there is nothing especially scary about owning stocks when interest rates are rising. Inflation, in fact, brings an advantage for equities relative to more conservative asset classes. The low fixed returns offered by cash and bonds look especially ugly in inflation-adjusted terms. The current 10-year U.S. Treasury yield is close to 2%. Considering 7% inflation, a 2% annual return becomes a 5% loss.

The caveat is that rising rates, when also accompanied by an economic recession, do typically lead to more financial damage. 1973-74 offers some evidence, but it's important to point out the modern Federal Reserve and Chair Jerome Powell have a history of erring firmly on the side of caution when it comes to pairing monetary policy with economic growth.

The U.S. economy will not continue growing at the annualized pace of 6.9% we witnessed in the last three months of 2021. But if rate hikes correspond with a major weakening of the economy, we can expect the Fed to adjust its policy accordingly.

Some sectors, of course, will fare better than others as interest rates increase. Historically, financial stocks tend to outperform. Utilities and communications services tend to lag.

Stock valuations contract during periods of rising rates because future earnings growth becomes less valuable when high inflation is taken into account. Stocks with the highest multiples (think: P/E ratios) become especially vulnerable. The recent underperformance of the Nasdaq demonstrates this phenomenon.