The graphs implied a weak statistical relationship between interest rates and stock market pricing, and little to no relationship between interest rates and credit spreads.
I’ve been postulating the opposite for a number of years. In my view, lower interest rates go a long way towards explaining the surprisingly robust markets in the years following the great financial crisis. Through this entire period, with part of 2018 almost looking like an exception, the difference between the earnings yield and the so-called risk-free interest rate has been consistently higher than in the pre-crisis years. Earnings could fail miserably and still imply a high opportunity cost for investors.
Furthermore, lower interest rates translate into a lower discount factor and thus a longer-term perspective, meaning short-term disturbances diminish in importance. How else can you explain the remarkable pick-up after the coronavirus lockdown and the realisation that it will produce an unprecedented decline in GDP? Barring the possibility of a mass hypnosis, it seems obvious that markets are looking well beyond the present troubles.
Of course, markets often get it wrong. That might certainly be the case this time as well. But that’s exactly why I’m not worried about the weak statistical relationship between interest rates and stock market pricing. The stock market oscillates between indefensibly high pricing and ridiculously cheap stocks – at least in retrospect.
In addition, comparing present pricing with, say, the 1920s, we miss the structural differences that dictate different pricing – like improved market governance, accessibility of information and liquidity. We would in fact expect the relationship to be a different one today, thus muddling the simple correlation.
So … yes, I still posit that the level of interest rates is of utmost importance in understanding the financial markets. If there is a conundrum here, it is in the disparate sighs of relief: The bond market does look a bit gloomier than the stock market. Global high-yield spreads are still more than 200 basis points above their pre-pandemic levels. Logically, even if such a divergence of opinion can be persistent, something’s gotta give.
I know what I’m banking on.
Finn Øystein Bergh
Chief Economist & Strategist
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