How Rising Interest Rates Affect Stocks

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's talk a little bit about why stock investors generally should care about rising rates at all. Obviously, for bond investors that linkage is pretty clear. Why should stock investors care about these rising rates?

Coffina: All assets are really, the valuation is really determined by the future cash flows that the asset's going to provide discounted back to the present at some discount rate. Stocks, just like bonds, have a discount rate associated with them. In the cases of stocks, we're usually talking about the cost of equity - which our analysts use 10% cost of equity on average - meaning that's a return required by investors in a fairly valued stock, and interest rates are a component of the cost of equity.

If a rise in interest rates were to occur completely in isolation, you would think that the discount rate would go up, future cash flows would be less valuable today, and stock prices would go down; again, holding all else equal.

Glaser: How does this actually work in practice? In other periods of rising rates, how have stocks performed?

Coffina: The problem is that all else is pretty much never equal. So the cash flows also tend to go up when interest rates are rising because the economy tends to be strong during those periods. I think the Fed has been very clear that they are only going to be raising interest rates if it's in conjunction with a stronger economy, if the economy can handle it.

Similarly, the interest rate is a component of the cost of equity, but there is not a direct correlation there. So, in our view stocks never really anticipate interest rates, 10-year Treasury rates, to stay below 2% forever. They never are really pricing that in, which means that stocks were somewhat less exposed to higher interest rates and bonds to begin with. Another component of valuations is growth, and once again we would expect growth, in general, to be correlated with higher interest rates, so that higher interest rates are not necessarily, when considering all of these other factors, bad for stock valuations.

What we've seen historically is that stocks over the last 20 years have actually done far better during periods of rising interest rates than during periods of falling interest rates. Again, I would attribute that mostly to the economy being stronger during periods of rising rates. The aggregate return during periods of rising rates has been over 280%. On the S&P 500, during periods of falling rates the S&P has only increased about 65%. Two events, in particular, had a big impact on that: That would be the financial crisis - interest rates were falling during that period as the Fed tried to react to the financial crisis - and in the early 2000s, the busting of the technology bubble. Again, the Fed was cutting interest rates at the same time that the market was crashing.

Glaser: It sounds like a time when investors could potentially do well even as rates are going up. But is that impact felt evenly across sectors, across different types of stocks, or are there more differences between them?

Coffina: What we find is, exactly as you might expect, more defensive sectors that are more bondlike that tend to pay relatively high dividends, have relatively slower growth, and are less exposed to the economic cycle. Those stocks tend to do the worst during periods of rising rates. On the other hand, companies that are more economically sensitive, technology, basic materials, energy, sectors like that tend to do better during periods of rising rates, again, when the economy is relatively strong. I think investors should probably be cautious with those more defensive sectors if they do expect rates to continue to rise.

On the other hand, we also have to consider where current valuations are. Interest rates - the 10-year Treasury, again, is already up to 2.9% or so from a low of below 1.7% earlier this year. To a significant extent we think that the market has already incorporated rising rates in stock valuation. So it's not necessarily the time to rush out and buy a bunch of cyclical sectors because you're worried about rising rates. The fact that this is on every investor's mind means that it's almost too late to do anything about it.

Glaser: That being said, are there any ideas right now? Is there anything you can buy if this is already all priced in?

Coffina: We have a few companies in the Tortoise and Hare portfolios that I manage that are relatively less exposed to higher interest rates, but again the valuations tend to be pretty full. Companies that come to mind would be Charles Schwab, Paychex. These companies were much cheaper earlier this year when everyone thought the low interest rates were going to last relatively long time than they are today when everybody is already anticipating rising rates and we've already seen rates rise quite a bit.

On the more defensive side, I think that they are actually more relatively undervalued opportunities. So, ITC Holdings would be an example: one of my favorite utilities, not quite as defensive as some other typical utilities because it has relatively faster growth. So it shouldn't be as negatively exposed to higher interest rates. And we think that the valuation is relatively compelling, given that it has a low degree of uncertainty.

Another name that comes to mind is Coca-Cola, again, a relatively defensive name. Not particularly exposed to economic cycles, and you might think that it would be more exposed to higher interest rates, but at the same time, we think the valuation right now is relatively attractive for a very high-quality company in a market that's been on fire this year and that there is relatively few bargains to be found. I think Coca-Cola is a wonderful business at a reasonable price.

Glaser: It sounds like rising rates are not something, a lot of stock investors should lose too much sleep over?

Coffina: Yeah, I think, again, judging from history, what we'd really have to worry about is when interest rates stop rising, when the economy starts to deteriorate and interest rates are falling. That's when you really have to be concerned. Rising interest rates on their own are not necessarily something to keep you up at night.

Glaser: Matt, thanks for joining me today.

Coffina: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.