Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, March 5th, at 2:00 p.m. in London.
Interest rates are moving higher, and a question that keeps coming up is at what level will this be a problem for markets. One can obviously say 'now', as this week saw a big rise in yields and some major market volatility, but I think this question is more complicated—about shades of gray rather than black and white.
In lots of articles and conversations, the idea that higher interest rates lead to weaker markets is presented as something that's relatively obvious. But it's not. For most of the last 30 years, global stock and credit markets have done better when yields are rising and worse when they're falling.
To understand why, let's think about how assets are often valued. When you value something that produces income over time, say, earnings or dividends or rents and so forth, two variables are usually paramount. One is the discount rate, the hurdle rate that people demand for accepting the risk of this investment relative to doing something else. As bond yields rise, this discount rate can rise too. If I can earn a higher return in a safe government bond, other things need to offer higher returns, and probably lower prices, in order to compete.
But there's also a second factor: how much those earnings, dividends or rents will grow over time. The faster this rate of growth, the more that same investment is going to be worth.
I think you can see where I'm going. Bond yields tend to rise when economic optimism improves, which puts downward pressure on prices through that higher discount rate. But more economic optimism can also raise expected growth, putting upwards pressure on prices. These two forces are often battling each other, but in the end, optimism frequently wins.
But where this trade off really matters is underneath the market's surface. As you've heard us discuss on this podcast recently, cheaper parts of the market are finally outperforming. Many of these cheaper areas of the market have suffered from low expectations of future growth. That gives room for improvement, as these growth expectations get better with rising economic optimism.
At the same time, expensive stocks that are already expected to grow very quickly, are finding it hard to kick those growth expectations up another notch, and thus are having a hard time offsetting the impact of those higher interest rates. Overall, higher interest rates and better economic growth are preferable to the alternative, but it's a bigger challenge for areas of the market that are already expensive, popular and enjoy high economic optimism. We have a value bias, globally, and see Europe as a region that's less expensive, less popular, and less exposed to the negative impacts of higher bond yields.
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