Dear Readers,
It's pretty much a foregone conclusion that interest rates are headed higher again, probably as soon as next week. This raises the following issue: Do higher interest rates mean trouble for stock prices? Put another way, will higher rates cause stock prices to fall?

First of all, keep in mind that when the Federal Reserve began to gradually raise short term interest rates back in June, the so-called "federal funds rate" — which only affects banks directly, but which indirectly has an impact on things such as what you earn in a money market account and the rate you pay on your credit card — was at its lowest point in more than 40 years: 1 percent.

In fact, when you subtracted out inflation of roughly 2 percent, the "real" rate of return was negative 1 percent. In other words, anyone who kept their money in an account paying around this rate was losing purchasing power because their money wasn't increasing fast enough to overcome the impact of inflation.

Let me demonstrate this using a simplistic example. Let's say something you buy today — a cup of coffee, for instance, costs exactly $1.00. If inflation is running at an annual rate of 2 percent, then a year from now that same cup of coffee should cost $1.02.

At the very least, then, you want your income to increase by at least 2 percent so you can still afford to buy the same things next year, right?

But if you keep your money in an account that's not even earning a rate of return equal to inflation, you're losing ground. A dollar invested in a savings account that only pays 1 percent will be worth $1.01 a year from now. Which means you've got to kick in an additional penny to buy that coffee.

This doesn't sound all that drastic when we're talking about cups of coffee. But the amounts get serious rather quickly when the item you're buying is worth thousands of dollars such as a car or a home, or — eeeeek! — college tuition.

The point is, it's not "normal" for short-term interest rates to be lower than the inflation rate. According to Joe McAlinden, Chief Investment Officer at Morgan Stanley Investment Management, in light of current inflation and unemployment levels, short-term interest rates should be around 3.5-4.0 percent. So at a current level of 1.5 percent, they're still lower than inflation.

Why has there been such a drastically different relationship between inflation and interest rates in the past year? The Federal Reserve was keeping interest rates artificially low in an effort to boost the economy — both consumers and businesses spend more when the cost of financing their purchases is low — and to head off what a number of so-called experts were wringing their hands about: the prospect of deflation.

Remember those dire warnings about the "D" word in spring 2003? Instead of prices going up, they were expected to start falling as they did in Japan in the early 1990s. You know that car you need? Well, next year it's going to cost even less. Ditto for that new house you want and the vacation you plan to take.

What's wrong with that?, you might ask. Plenty. Think about what you do when you hear something you want is going on sale next month. Do you rush out and buy it today? No way. Instead, you wait. And so does every other consumer with half a brain.

Except what happens if you're the car dealer or the real estate agent whose income depends on making the sale? Poof! Next thing you know, you're out of work. And the whole things turns into an endless downward spiral. Because people expect things to cost less in the future, they postpone making purchases. Companies postpone making things because no one's buying and since they've got plenty of inventory built up, they start laying workers off. Next thing you know, prices have to be slashed even further because family incomes are down (Mom was laid off) and in order to attract buyers you've got to reduce your prices. Profit margins continue to get squeezed. Businesses go toes up. Unemployment skyrockets. The economy grinds to a halt.

Deflation is ugly.

So the Federal Reserve took the highly unusual step of lowering interest rates below the level they should have "normally" been at in order to make it attractive for companies and consumers to keep spending. [That's what keeps people employed.]

Which brings me to point No. 1 and the reason why a number of very smart folks are not at all worried about the Federal Reserve's recent moves to raise interest rates: They see the move as a signal that the Fed believes the economy is now strong enough to continue to grow without the prop of artificially low interest rates. In other words, deflation is no longer a worry. And neither is rampant inflation like we saw during the 1970s. At this point, the Fed just seems to be nudging interest rates back to where they should "normally" be in a healthy economy.

Let me repeat that: this economy is healthier and stronger than the headlines would have you believe.

What's this got to do with stocks? Keep in mind that stock investors can get paid in two ways: dividends, which are a share of the profits a company earns, and capital gains, which is an increase in the stock's price. If the economy is strengthening, then corporations should make more money. Whether they pay it out in the form of dividends or use their higher profits to expand their businesses, higher earnings lead to higher stock prices.

Joe McAlinden also points out that there are four phases to the business cycle. Phase One is when the economy is in or near recession, which causes interest rates to fall. Eventually things get better and the economy starts to pick up. In Stage Two, corporate earnings begin to grow again, unemployment declines, and we may start to see signs of inflation.

By Stage Three, corporate America is really cooking, profits are strong, and the Federal Reserve starts to increase interest rates to slow things down a bit so that inflation doesn't take off. The fourth stage is when rates hit a peak, economic growth slows, and so do corporate profits.

According to McAlinden, we're currently in the third stage of the business cycle, a period that can conceivably last years. The economy is growing at a much faster clip than experts predicted a year ago. And, in case you haven't noticed, corporate profits have been going gangbusters. In both the first and second quarters of this year, earnings grew by <more than 20 percent > compared to the same periods in the previous year. Typically, the growth rate is closer to 7 percent.

As we approach the end of the current quarter, the time when corporations announce profits, we're starting to hear a lot of noise about earnings being "below expectations." You'll probably read that "earnings growth is slowing." Don't let the headlines take your eye off the ball! According to Morgan Stanley, current estimates are that year-over-year operating earnings are going to be up 15% this quarter. That's still TWICE the norm!

"This is an excellent time to make sure your asset allocation is up-to-date and you haven't drifted too far into bonds," says McAlinden. In other words, don't let the gloom-and-doomsayers talk you into heading for "safety." There still plenty of room for stocks to rise and at this point, bonds are hardly "safe." Rising interest rates cause the value of existing fixed income securities — bonds, notes — to go down.

Take a look at this chart compliments of Morgan Stanley (pdf). It compares the yields on the S&P 500 and the 10-year Treasury. Think of "yield" as what you get paid for every dollar you invest. For stocks, it's Earnings divided by Price (the opposite of P/E). Typically, the interest you receive on a bond is higher than the dividends you receive on stocks. But not now.

Notice that the last time the yield on stocks was below the yield on bonds was the early 1980's, the start of a huge bull market in stocks. While no one's predicting that sort of move today, the key is that in order for these numbers to move into a "normal" relationship one of two things has to happen: Either stocks have to go up in value or bonds have to go down in value.

While Morgan Stanley expects bonds to slightly lose value as interest rates are gradually increased, they believe most of the move is going to come from higher stock prices.

If you're still not convinced, try this: McAlinden points out that with only one exception, in the second half of an election year the stock market has always posted stronger returns than in the fist half.

Keep the faith,

Gail

 

Source for the chart: Morgan Stanley Investment Management. Data is historical. Past performance is not a guarantee of future results. The S&P 500 Index is an unmanaged index of common stock performance. It is not possibly to invest directly in an index.

 

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