Rising Global Interest Rates Create Headwinds
Bill Hester, CFA
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Measuring the potential risks and returns of investing in either the EAFE Index or the S&P 500 Index can be accomplished with many of the same factors – levels of valuation, internal market action, and interest rate trends, to name a few. There is an additional benefit to measuring market conditions in more than one country. The EAFE Index, which is made up of 21 developed markets outside of North America, can be analyzed country by country, for example, to produce additional measures beyond the ones available for the index as a whole.
Different levels of these ‘aggregated' market characteristics – whether based on valuation, trends, or interest rates – are often associated with distinct average returns historically. It's worth examining interest rates today, because recently they've been rising in strong unison. The table below shows the change in basis points in the 10-year yield from 6 months ago, for each country tracked by the EAFE Index (plus Canada). A brief look at the table shows that the interest rates of every country in this group have climbed higher during the past six months, and a few have risen materially.
Interest rates are rising in these countries for different reasons. Some bond investors are concerned about strong growth, while others are focused on immediate inflation pressures. The difference between nominal and inflation-protected bonds show that implied inflation in Sweden is just 2 percent, while it's more than 3 percent in the UK. The bond investors in a few of these countries, of course, are concerned about the return of their principal.
While it may seem typical for all developed market interest rates to rise together, it's actually a rare occurrence (all interest rates falling together tends to happen more frequently). The graph below shows the percent of countries with interest rates above their levels of six months ago. As the chart shows, a complete agreement in rising interest rates has happened only a handful of times. (This data – particularly in the 1970's - is based on the percent of the total number of countries where interest rate data is available.)
A 100% unity of rising interest rates has occurred in only a handful of months, in early 1973, in 1980, late 1999, and in July of 2006. The outcomes were mixed. The global bear market of 1973-1974 followed the first instance. Positive returns followed the other occurrences, though the last three were followed by substantial declines about a year out.
Relaxing the conditions to include more periods is informative. The table below shows returns over 1-Mo, 3-Mo, 6-Mo, and 12-Month time spans following periods where the percentage of countries with rising rates was either low or high. For this discussion, we'll suggest that a low percentage is 35 percent, and a high percentage is 65 percent. The table summarizes the results.
This is a fair representation of how investors should think about the role higher interest rates play in regard to international stock performance. There have been big declines kicked off by a growing concordance of rising interest rates, including the 1973-1974 bear market, the 1987 crash, and in 2000. But gains have followed periods of rising rates as well. Overall, the EAFE Index has had little or no net gain, on average, during periods where many individual countries were experiencing higher interest rates. The bulk of the positive returns for the EAFE Index have come during periods when there were a growing number of countries in which rates were falling.
Central Bank Tightening
The phrase ‘Central bank tightening' is coming back into the investor lexicon, after a 3-year hiatus helped by incredibly easy monetary policy worldwide. The ECB raised its lending rate earlier this month, which was the first change since 2009. Other countries are further into their tightening cycles, such as the Reserve Bank of Australia and Sweden's Riksbank. Recent shifts have now led to a majority of countries in the EAFE Index with tighter monetary policies. The graph below shows the percentage of countries where central bank rates were higher than 6 months ago (therefore highlighting only periods where policies were actively getting tighter).
The table below shows the same set of returns for the EAFE Index following periods where either few or many central banks were tightening policy. I've kept the same set of conditions, where the low percentage is 35 percent and the high percentage is 65 percent. Other thresholds create even greater dispersion between the results. But for this discussion, I've kept the same levels that were applied to the change in longer-term interest rates.
Returns were usually strong following periods where central banks were easing policy or were leaving it unchanged. Where more than 65 percent of central banks are increasing short-term interest rates, however, forward returns become negative for every time period.
This table highlights the same pattern as the first. On average, investors have experienced negative returns during periods when a growing number of central banks are tightening policy. Strong gains, on average, have followed periods where most central banks were easing. While there is notable variation around these averages, it's clear that rising interest rates – whether focusing on market interest rates or central bank rates – create a headwind for investors.
For the curious, the table below shows the average returns during overlapping periods. Returns are strong – more than 20 percent over the following year – in cases where a growing number of long-term interest rates and central bank rates are falling or are unchanged. Negative returns, on average, have occurred during periods where long-term interest rates and central bank rates were both rising in the majority of countries.
Bond yields are higher than they were six months ago in all of the 21 countries in the EAFE Index. Almost two-thirds of the countries in the Index have central banks that have begun to tighten monetary policy. This needn't lead immediately to big corrections or bear markets. But it's clear from the historical results that essentially all of the gains that have occurred in the EAFE Index, on average, have occurred when long-term rates and central bank rates were falling or unchanged in a majority of developed countries. Essentially no net gains, on average, have occurred during periods of strong international agreement in the form of either rising long-term interest rates or rising central bank rates.
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