Year-to-date (May 2, 2022) and over the last 12 months, both stocks and bonds have lost money. Generally, we think of bonds and stocks as diversifying one another. Lately they’ve been moving in the same direction. What’s going on?
Here is what usually happens. Interest rates are the prices to borrow money and are the primary driver of bond returns. As the economy improves there’s more demand to borrow money so rates rise. An improving economy means more growth which is good for companies and their stocks. In this scenario, bond prices fall, and stocks rise. On the other hand, as the economy falters, as in a recession, interest rates fall so bond prices rise. As the prospects for growth diminish, the stock market weakens. These scenarios are why bonds and stocks are commonly combined to diversify portfolios. Stocks do well when there’s unexpected growth; and bonds do well when growth unexpectedly slows. Over the past 173 quarters (43 years), just eight quarters (less than 1 in 20) have experienced negative returns for both the U.S. stock market and the U.S. bond market. That happened in the first quarter of 2022 and, so far, the second quarter is tracking in the same direction.
So why isn’t that happening now? The short answer is that interest rates are rising, but growth expectations are not. Consequently, the future dividends of stocks and the future interest payments from bonds are both worth less.
That was a simple answer, and probably satisfies most readers. That real rates have risen is the more technical reason that stocks and bonds have both lost value. Real rates are rates adjusted for inflation. If inflation is 3% and an investor earns 5%, he or she has enjoyed a 2% real rate before taxes.
Real rates can be observed from the yield on Treasury Inflation Protected Securities (TIPS[1] )[1]. Currently, the real rate is 0.18% on a 10-Year TIP, up 1.15% from -0.97% at the start of the year. A negative real rate indicates investors are getting a return less than the rate of inflation as was the case at the start of the year. Today’s real rate of 0.18% indicates investors are earning a return slightly greater than inflation.
The interest rate on the 10-Year U.S. Treasury (not TIPs) jumped from 1.63% at the first of the year by 1.36% to 2.99%. The bulk of the change in interest rates is accounted for by the 1.15% increase in real rates. Inflation expectations rising from 2.60% by 0.21% to 2.81% accounts for the remainder.
An increase in real rates hurts both stock and bond investors whereas rising inflation mainly hurts bondholders whose interest payments are fixed. When there’s inflation, companies increase prices -that’s basically what inflation is after all. Even if their expenses rise by the same rate, their profits rise. A company with revenues of $100 and expenses of $80 that experiences 10% inflation will see its profit increase 10% from $20 to $22.
Where do real rates go from here and how will bonds and stocks be affected? Our loyal fans know we don’t try to time markets and promote diversification. Based on the history in the preceding chart the rate could come down or continue to rise. We’d expect markets to suffer if the rise continues and to recover if it reverses.
Here is one scenario. How much might a 1% rise in real rates be expected to impact the stock market? A simple model provides insight. The simple model assumes that stocks (think the S&P 500) pay a dividend that will grow by some amount (g) indefinitely. Let’s assume that g is 4% or 5% which is a ballpark long-term rate for the U.S. stock market. There is some rate at which we discount future dividends to convert them into today’s dollars. For starters, let’s use 6%. The simple model says the price of the stocks will be the dividend value divided by the difference between the discount rate and the growth rate: P = D / (k – g). Some math allows us to calculate the percent change in the stock price if k increases 1% as % change = (k – g) / [(k + 0.01 – g)] – 1. Assuming a 4% growth rate with the discount rate rising from 6% to 7%, the model indicates a 33% drop in stocks (-33% = (0.02/0.03) – 1). Here are results with different assumptions:
| g | 4% | 5% | 4% | 5% |
| k | 6% | 6% | 10% | 10% |
| k+1% | 7% | 7% | 11% | 11% |
| % Change | 33.3% | 50.0% | 14.3% | -16.7% |
The point of the table is to show that a 1% change in the real rate can easily explain a double-digit drop in the stock market. Given how low rates have been, we’d argue that k was likely closer to 6% than 10% at the start of the year. So, we may have gotten off lucky; otherwise, we may have more pain to endure.
It’s worth discussing what drives real rates. Demographics are a driver over the long term. The ratio between people 65 years and older and people 15 to 64 years old is an example. As people save, particularly for retirement, they increase demand for investments. Retirement spending tends to reduce demand. Higher demand reduces the real rate while lower demand increases it. In the short run, the Federal Reserve, especially with its massive bond buying, creates demand for securities. It is possible, even likely that anticipation of tightening by the Fed is pushing real rates higher. What does all this mean? There’s good news here. Whereas investors in the 10-year Treasury were expecting to lose almost 1% annually after inflation, they can now expect a positive, albeit small, inflation-adjusted return. For those who are adding to their investments, higher real rates are more attractive. Understanding that movements in interest rates can be attributed to changes in the real rate and changes in inflation expectations brings important information to light. We also expect value stocks to outperform growth stocks when real rates rise. Here we are broadly categorizing stocks with higher earnings and dividends per dollar of market price (lower P/E, higher dividend yield) as value and higher P/E, lower dividend yield stocks as growth. Growth stocks are expected to get more of their value (earnings and dividends) farther in the future than value stocks. If real rates rise, but growth expectations do not), the valuation of growth stocks will suffer more than that of value stocks.
[1] TIPs are bonds issued by the U.S. Treasury. The principal is adjusted by the rate of inflation and interest is paid on the adjusted principal thereby providing a return relative to inflation.