CIO thinks there are sound reasons why stocks have been resilient in the face of the sharp move higher in interest rates. (UBS)

While interest rates are an important component of equity valuations, they are just one part of the equation. Literally. The P/E ratio = cash flows / (discount rate – growth rate).


The discount rate is correlated to treasury yields, but the two don’t necessarily move in lock step. Furthermore, if interest rates are rising due to a stronger economy (which seems to be the case today), then expected earnings growth should also be rising. A higher discount rate drives lowers valuations but a faster growth rate increases them. We think this largely explains why equity valuations—and equity markets—have been fairly resilient in the face of the recent increase in interest rates.


But history does suggest that a 10-year Treasury rate greater than about 6.5%leads to lower valuations. It’s hard to know if this “tipping point” is still valid today. It's possible it could be lower because potential nominal GDP growth is lower than in the past. In our mind, the main risk to stocks is if higher rates ultimately lead to a pronounced slowdown in economic growth. Today's trailing P/E of 19.5x and a 5% 10-year is at the upper end of the range (excluding the dotcom bubble), but consistent with history.


It’s true that the rise in rates does make stocks look less attractive versus bonds. The spread between the earnings yield (earnings / price) on the S&P 500 and the 10-year Treasury rate—the equity risk premium—has fallen to the lowest level in over 20 years. But the level of the equity risk premium does not look alarming. There was a long period from 1980 to 2000 when this spread was even lower than it is today.


Our bottom line: We think there are sound reasons why stocks have been resilient in the face of the sharp move higher in interest rates. And stocks will likely remain resilient as long as the improvement in corporate profit growth comes through as expected.


Main contributors: David Lefkowitz, Nadia Lovell, Matthew Tormey


Read the original report : Rates and stocks: not so straightforward, 20 October 2023.