from the April newsletter from Provident Investment Management
In December 2015, the Fed raised interest rates slightly after maintaining them near zero since the global financial crisis. It also suggested that it might raise them two or even three more times in 2016. During the year, it reassessed that further rate hikes weren’t warranted as growth and inflation expectations remained subdued. However, it ended up raising rates a modest quarter point soon after the 2016 election and suggested three more increases could happen in 2017. In recent weeks, Fed officials have talked about raising rates a bit sooner than many Fed watchers expected and decided to raise them at its March 15 meeting. The Fed continues to believe that a total of three rate hikes will ensue this year, and investors were relieved that it hasn’t changed its forecast at this juncture.
Higher interest rates have historically been negative for stock prices for three reasons:
- A steady pattern of rising rates tends to slow the economy down, which is typically the desired effect in order to prevent inflation from getting out of hand.
- Higher rates can also draw investors to income investments like bonds and away from growth investments such as stocks.
- Many investors value stocks by discounting future cash flows; higher rates produce lower present values for a given series of cash flows.
One could make the case that lower interest rates in recent years should have resulted in higher stock prices given arguments two and three from this list.
Rates are rising for the best of reasons: the outlook for stronger economic growth. Continued interest rate hikes could eventually spell trouble for the economy and the stock market, but rates were at all-time lows not that long ago, and modest increases still leave them well below any conceivable danger zone. We don’t see any reason for investors to change their behavior as a result of higher rates.