It is never easy to know what is ahead for capital market returns. Stocks have survived one of the quickest restrictive policy pivots known in Federal Reserve history as well as March’s regional bank crisis. Conversely, traditional assets that diversify stock market risks haven’t experienced the same recovery as global equities. But the only constant investors learn to live with is one characterized by a spectrum of continuous change. And new change has hit the bond markets in a significant way, namely in the form of higher interest rates.
At the beginning of the year, investors feared that the aggressive interest rate policies would send the economy into recession. However, nothing has been further from the truth to date. US GDP recorded in the second quarter of this year beat expectations by a wide margin. The first indicator measured economic growth at 2.4% annualized, as the economy saw an upturn in private inventory and non-residential investments. Moreover, personal incomes and savings have grown as jobs have remained available and plentiful. And all of this good news has happened in an environment of tougher credit standards.
As anticipated by markets, the Federal Reserve raised interest rates for the fourth time this year. Many market participants believe July’s decision was the last rate increase for the remaining year. The Fed Funds rate is now 5.5%; prime borrowing rates for top-rated corporations have reached 8.5%; it now costs consumers 7.4% on a 30-year mortgage; and the government pays about 4% to investors for 10-year loans. Having liabilities at these costs isn’t ideal, but these rates haven’t looked this good for investors with assets in a long time. But regarding stocks, how much higher must interest rates rise before bonds become more attractive relative to equities?
Price divided by earnings represents the earnings multiple on stocks, and it’s believed to be about twenty-five times on a basket of the market’s largest stocks. The reciprocal of twenty-five results is 4%, which can represent an earnings yield proxy for stocks. However, these stocks may yield more than 4% because the simplified model lacks information about the growth of the market’s future earnings. Therefore, stocks realistically yield more than 4% if the model acknowledges that earnings should grow. But if uncertain and random variables push the rate of growth below expectations, the stock yield in the marketplace could be at risk of looking weak compared to market interest rates on bonds.
For the first time in a while, investors can choose between two real-life opportunity costs. Should investors lock in higher fixed-income guarantees from bonds and forfeit the risks associated with stocks? Or should investors continue to increase risk allocations under the presumption that stocks appear undervalued against a bright and prosperous future filled with new technologies? Whenever bonds experience yield increases throughout the entire marketplace, the opportunity costs of stocks intensify.
Inflation rates have indeed moderated due to the normalization of global supplies and the swift actions of global bank regulators. This is seemingly allowing investors to capture attractive investment premiums in the market today. Specifically, investors can earn a spread over the expected inflation rate using treasuries which now offer rates in the range of 4% to 5%. When investment yields outstrip forward inflation rates, it’s known as a real yield on interest, and real yields have been in decline since the mid-80s and practically disappeared following the big recession of ’08. So, finally, it’s a welcomed change in the investable universe to see real yields resurface.
Robust stock returns and new opportunities in bond market interest rates offer investors a variety of options today. It can often be intimidating for investors to navigate this shifting investment landscape. That is why many successful investors adhere to clearly-defined investment principles and have a well-articulated financial plan running in the background. Financial plans help keep investors focused on their long-term goals and strive to prevent them from making harmful investment decisions.
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