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Interest rates and stock market valuations

We look at the impact of interest rates on stock markets, and specifically what that means in the US.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

One of the most striking financial developments of recent decades, has been the long term fall in global interest rates. It’s a trend that stretches back to the 1980s.

The graph below shows the falling yield on benchmark US government bonds over the last 45 years – a standard measure of interest rates.

Scroll across to see the full chart.

Chart showing 10 Year US Treasury Yield

Source: Federal Reserve Economic Data 09/01/20.

What do lower interest rates mean for investors?

Assets, like stocks & shares, property and commodities, are valued relative to other possible investments – including lower risk investments like government bonds. If the yield available on government bonds goes down then higher risk, but potentially higher returning, assets become relatively more attractive. Investors move to buy these assets, pushing up their prices.

A higher price, with no change in underlying profits, interest or rental income means future returns fall. Dividend yields, bond yields and rental yields will all be lower, in line with the lower interest rate.

In short, lower interest rates mean higher asset prices – and that includes everything from stocks & shares to property or gold.

The point is, price-to-earnings (PE) ratios today can’t just be compared directly with the past. Not only have the individual companies changed, but so have interest rates. All things being equal, we would expect PE ratios to be higher today than forty years ago, simply because interest rates are lower.

What about the market today?

When you see that the US stock market trades on a PE ratio of 24, compared to a post-1975 average of 17, it can be tempting to jump to the conclusion that the market is expensive. But that’s not necessarily the case.

Scroll across to see the full chart.

Chart showing Interest Rates and Market Valuations

Source: Refinitiv, Federal Reserve Economic Data 09/01/20.

The chart above plots the PE ratio of the whole US stock market against US government bond yields.

The relationship isn’t perfect, and it looks like the market got out of kilter during the dot-com bubble and fell heavily during the financial crisis. Generally though, the stock market has performed as we’d expect. As interest rates have fallen, stock market PE ratios have increased.

In fact the current stock market PE doesn’t look wildly out of step with historic trends.

We’re not saying the US market is over-, under- or fairly-valued – because apart from anything else the stock market didn’t include any Amazon’s, Google’s or Apple’s back in the 1970s. What we do think is that lower interest rates make it problematic to compare the PEs today with those from before the financial crisis.

What does the future hold?

Of course there’s a less comforting side to this story too.

If stock market prices rise when interest rates fall, then by the same logic if interest rates rise you’d expect to see the reverse. Not just stock markets, but other asset classes like property or gold, could see their valuations fall. Lower PE ratios don’t necessarily imply lower prices – if profits rise they could more than offset the decline in rating – but it’s certainly a major headwind.

Global interest rates are close to historic lows. And while we don’t know where rates are headed, it’s fair to assume they will be higher at some point in the future than they are today.

Does that mean you should stay out of the stock market? We think not – after all there’s no way of knowing when a major change in interest rates will happen, or if it will at all. However, we do think it’s a strong argument for holding a well-diversified portfolio, and a good mix of asset types, including cash.

This article is not personal advice. If unsure, please seek advice. Unlike the security offered by cash, all investments fall as well as rise in value, so you could get back less than you invest.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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