Interest rates, economic cycle and stock returns (Part I)

There are several fundamental factors, which align economic policy, markets, and the general business cycle, which investors must be familiar with and follow closely. Understanding certain relationships between the above aspects of the investing universe could assist with building a sound portfolio strategy, with solid returns and well-managed risk.

Looking at the graph (above), one can distinguish four main stages of the benchmark interest rate evolution, which controlled by the central banks. It is considered a key monetary policy instrument and has many implications for investors. At each stage of the cycle, a portfolio rebalancing is required to reflect the dynamic of the general economic and market conditions. The outline (below) provides additional information as to what is happening at each stage.

Stage 1

• Demand for Government bonds increases and yields go down
• Risk assets (equity) are generally avoided
• Government fiscal stimulus in play – loans, infrastructure projects, direct payments and tax breaks
• Expansionary monetary policy in play – base rate cut and asset purchases
• Risk appetites start increasing towards the end of this stage
• Low inflation or even deflation, with small or negative GDP growth
• Unemployment is well above the 4-5% target structural rate

Stage 2

• Demand for bonds drops and yields start rising
• Investor confidence returns, risk tolerance is up and equity starts gaining ground
• Interest rates start stabilizing and central banks dial bond purchasing down
• Some Government stimulus measures are pulled back
• Inflation and GDP are showing signs of recovery
• More jobs are added and unemployment rates return to single digits

Stage 3

• Bond yields are quite high – public borrowing is limited, being expensive
• Investor confidence is peaking, with equity valuations overheating
• It is time to consider reducing risk exposure via cheap bond additions
• Contractionary monetary policy – interest rate increase and asset selling ensues
• Government is raising taxes and reducing public spending
• Inflation and GDP growth might be at above target rates
• Full employment feels within reach

Stage 4

• Yields start normalizing, with demand for debt soaring – inverted yield curve possible
• Investors pivot from equity to bonds, anticipating the next recession
• Stock yield strong dividends, but poor risk-reward ratios – poor capital gains
• Aggressive expansionary policy of interest rate cuts and asset purchasing in play
• Government is tracking fundamentals and considering stimulus
• Inflation and GDP start slowing down, with stagnant aggregate demand
• Unemployment starts rising towards double digits

The above outline illustrates the events that unfold within key segments of the markets and the general economy, as well as what courses of action are normally taken by different economic agents in line with the overall movements and turning points within the business cycle (a.k.a economic cycle).

Our exact position on the cycle’s curve (above) is usually very hard to tell, but the table above attempts to highlight key signs to watch out for in navigating the cycle. It is important to note that the interest rate movement is inversely related to the cycle’s trajectory. Low-interest rates are enacted when the economy is reeling and an expansionary approach is required to restart aggregate demand. When the cycle is peaking, it is time to jump on the breaks and avoid overheating by way of increasing base rates.

Since our main focus is investment strategy [and not so much economic theory], let’s look at what happens to stock returns when bond yields, a special type of market-driven interest rates of corporate and government nature, fluctuate. Volatility in bond yields has a lot to do with general economic conditions, the business cycles, and the application of different policy tools, as well as investors’ behaviour over different stages of the cycle. More about those relationships will be revealed throughout this series.

Bond yields vs equity returns

Bond yields are an important determinant of equity valuations and returns. Generally, as bond yields decrease, equity markets perform well (and vice versa) – inverse relationship. This relationship is especially strong in the long-term, while not so stable in the short-term. Several prominent factors underpin this relationship between bond yields and stock valuations, which investors often used to predict the direction of stocks.

1. Yields and opportunity cost of stocks

Stocks are attractive only if capital gains and dividend yield, combined with the required equity risk premium (for investing in a way riskier asset) exceed bond yields. Otherwise investing in equities does not make sense, since the investor is not being compensated for taking on the extra risk. With bond yields going up, equities become less attractive and investors rotate out to a better risk-reward ratio.

2. Yields vs earnings yield (or dividend yield)

Investors often compare bond yields to companies’ earnings yield [EPS-to-share price]. Some analysts/investors use dividend yield [DPS-to-share price] for companies with strong pay-out ratios instead. This is a measure of earning capabilities, which represents a stock return performance. So the stock yields needs to exceed the bond yield for this riskier investment to work. Or in other words, if bond yields are on the rise, the stock valuation [in terms of PE] needs to go down for investors to buy it, since Earnings Yield = 1 / PE ratio.

A small caveat – if the company is loss-making, but has a great potential or is undergoing restructuring, the above doesn’t hold and investing in the company might still make sense.

3. Bond yields, stock valuations and corporate borrowing

Base rate cuts are usually considered positive for equities due to the fact that valuations go up and corporate borrowing becomes cheaper. The opposite is true for interest rate hikes.

The most popular stock valuation method is the DCF model [FCFi or FCFe]. Benchmark yield [often the 10 YR US or German Bond] is used as a risk-free rate in deriving the company’s cost of capital [using the renowned CAPM model]. With bond yields increasing [all else being equal], cost of capital [Re] should increase, which will bring down the company’s valuation since Re is used as discounting factor for projected future cashflows.

Furthermore, the increase of bond yields [similar to a base rate increase] leads to higher finance costs for public, corporate, and retail borrowers. Firstly, higher bond yields would normally be followed by a base rate increase at some point to combat inflationary pressures. Secondly, rising bond yields can have a direct effect on borrowing costs – commercial banks tend to offer rates, which take into account not only base rates [making up the variable part of floating rates], but also the risk-free rate [gov bond yields] in deriving the bank’s required risk premium for both fixed and floating interest on both corporate and retail loans. Thus, when bond yields rise significantly, this inevitably leads to higher financial [default] risk, which is particularly bad for the valuation and future borrowing needs of smaller and highly leveraged entities.

It is important to note that after prolonged periods of heavy bond-buying [usually as a recession safeguard] yields are very low and when the economy starts showing signs of recovery, investors will simply rotate out of bonds and into equities, which will lead to yields rise. This is a straightforward supply-and-demand relationship, which leads to stock market boost and bond yields increase in the short-to-mid term and is different from the above concepts.

To be continued…

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