Macroscope | Interest rates are rising, but it isn’t all bad news for investors
- History suggests that if investors take a long view, returns will be positive through the tightening cycle
- Furthermore, inflation is likely to peak in the next few months, and the medium-term outlook for equity returns should be healthy
Equity investors have already seen significant negative returns in anticipation of higher rates. There may be more to come in the short term. However, history suggests that, if investors take a long view, returns will be positive through the tightening cycle.
The key drivers of returns are what happens to valuations and corporate earnings. In this cycle, some markets could become less expensive, while the outlook for earnings is much more positive.
Both valuation and earnings drivers are cyclical and tend to be weakened during periods of rising interest rates. The US Federal Reserve will soon begin raising interest rates and markets are pricing in six increases in 2022.
In Europe, the European Central Bank is expected to start moving away from negative interest rates this year, while the Bank of England has already pushed its key interest rate up twice. Around the world, the tendency is for interest rates to rise as markets lean against the highest inflation rates in years.
Typically, the beginning of the monetary tightening cycle is bad for equities. Markets tend to de-rate, meaning price-to-earnings (PE) ratios fall. This is driven by the relative valuation between equities and bonds.
