With Labor Day barely in our rearview mirrors, it may be a bit premature to sing a chorus of Auld Lang Syne, but a look back to the start of 2018 is still instructive.
No doubt the February selloff unnerved stock investors. At least temporarily. The volatility spike was scary, sure enough, but there was an underlying anxiety that made the market exquisitely sensitive to exogenous events. The anxiety? The prospect of higher interest rates. Many investors were, and still are, unsure about the impact of higher rates on stocks.
Much of anxiety centers around the equity risk premium—the telltale yield spread offered by stocks over the risk-free return of a U.S. Treasury obligation. A low-risk premium typically is the consequence of frothy stock prices, suggesting limited further upside. A fat premium suggests richer returns ahead and resilience to the depredations of higher bond yields.
A classic computation of the equity risk premium pits the expected dividend yield of the S&P 500 against the 10-year Treasury yield. For those challenged by the calculation of the present value of future dividend streams, a simple subtraction of the Treasury rate from the S&P’s current yield will suffice to paint the premium’s contours. Measured that way, the equity risk premium is currently 0.91 percent, well below its historic 2.82 percent average. The backdrop for this is a snug-up in the 10-year rate to 3.07 percent from its 2.41 percent level at the top of the year.
Keep in mind that a hike in interest rates won’t necessarily precipitate a knee-jerk reaction in equities. While higher yields are generally a headwind for stocks, the reason for the rise is every bit as important as the level attained. The equity risk premium may be cranked down when rates rise in anticipation of greater economic growth but can also vary with inflation expectations. The ability of companies to pass on price increases then determines the outlook for growth and the subsequent effect on the yield spread.
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