U.S.Equity Strategy:Higher Rates,Higher Valuations

Expectations are for a Fed hike in December and for a tight labor market to putupward pressure on longer-term rates. This, along with changes at the Fed, israising investor concerns that higher yields will impede the market’s advance.

    Conventional wisdom holds that rising rates threaten equity valuations. Bycontrast, the data shows that when yields are depressed—as they are today—stock prices and interest rates move in tandem.

    The question, then, is at what point rising rates become a burden.

    As Figure 1 shows, P/Es have historically moved higher until the 10-yearTreasury reaches 5%. However, the research presented in this note showsthat this tipping point has likely fallen to 3?%, in response to the currentslower-growth environment. With Treasury yields below 2?% today, thisimplies that stock valuations will not be challenged by rising rates for quitesome time.

    While investors typically focus on the effect of the Fed’s actions on stockprices, changes in longer-dated Treasuries have a far greater impact. Further,the correlation between Fed Funds and multiples has largely broken downsince the introduction of uber-accommodative policy in 2008.