Stock markets certainly drew a sigh of relief in October, most conspicuously so for a somewhat outdated index: The Dow Jones Industrial Average had its best month since January 1976, returning a full 14%. Broader market indices on both sides of the Atlantic rose by roughly half as much, which still leaves nothing to complain about.
The relief may be temporary, though. A few days into November markets fell again, after further rate hikes by several central banks and the proverbial scrutiny of their statements and informal remarks. The past few years, offering first a pandemic and later the outbreak of a brutal war, have laid all doubt to rest: Nothing moves markets like interest rates. At least in the short and medium term, I would add.
How do interest rates affect longer-term returns in the stock market? Is it possible that much of the impressive long-run return is a function of falling interest rates?
Here’s a very simple exercise to examine the role of key rates. Let’s look up previous dates with rates at present levels. The US Federal Reserve just increased its key rate to 3.75% (lower bound). If we go back more than 30 years, we find a matching rate in July 1992.
In the ensuing years, the S&P 500 has returned more than 1,600% including reinvested dividends. That translates to an annual average return of 9.8%.
You see the point of this exercise? There’s no way this return can be ascribed to falling key interest rates, given that they are back to where they started. In a sense, this is an interest-rate neutral return.
In Norway, the key rate was just increased to 2.5%. We had 2.5% back in December 2003. In the intervening years, the Oslo Børs benchmark index has amassed an aggregate return of more than 600%, equivalent to an annualised return of 10.9%. Not bad – and not due to falling key rates.
Of course, interest rates are not limited to key rates, although these tend to get the most attention. As some of you may recall or suspect, yields on the 10-year US government bonds were higher in 1992. Yields on 1-year bonds, however, were lower; the yield curve was steeper. Yes, that’s supposed to signify higher growth. But the associated horizon is a year or two, not 30 years. The same holds for Norway in 2003, by the way: Long market rates were higher then, but low rates were lower.
Admittedly, I’ve left inflation out of the picture. You may argue that the market should be more concerned with real rates (in which case long bond rates weren’t higher in 1992 after all). They are, however, not as readily visible, not unambiguous, and not clearly defined. Forward-looking inflation is but an estimate, clouding expected real rates, and the market is not very concerned with current real rates. This year, current inflation has risen by much more than both key rates and market rates. The stock market does not seem to be delighted.
Of course, interest rates may still be important. If, say, they kept a total meltdown at bay in 2008 or in 2020, they may have smoothed an otherwise even bumpier ride. My point is simply that for the stock market, long-run returns are generally driven by something else than interest rates, or key rates in particular.
Meanwhile, we are not done with hikes yet. While comments by, say, Fed chair Jerome Powell may be more important than the actual rate path, we are bound to get more bad news. And the market may be disproportionately preoccupied with looking on the not-so-bright side of life. A recent working paper from Norges Bank discusses the reaction to different news categories, with the interesting conclusion that there may be “a substantially higher information content of bad news” than of good news. While they focus on consumers’ reactions, one may surmise that the same goes for investors.
Just remember, then, that in the long-run, interest rates are a lot less important than they may seem now.
Finn Øystein Bergh
Chief Economist & Strategist
Fund updates for October 2022
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