What to expect in this article
What do we mean by rising interest rates?
That may sound like a daft thing to ask, but there are many different types of interest rates beyond the central bank rate set by the ECB in Europe or the Federal Reserve in America. Of course, these bank rates set the tone but, when thinking about our equity ETFs, it makes more sense to look at the behaviour of government bond yields. These yields emerge from bond market interest rates that are heavily influenced by central bank rates, but also investors’ views on inflation, economic conditions, credit ratings, and more. Government bond yields directly influence the performance of our fixed income ETFs. But they have consequences for equities too – because stocks and bonds compete for the same investment capital. Higher bond yields make government debt more attractive relative to equities. And that mechanism can reduce demand for stocks, causing prices to fall. The same often happens in reverse. When bond interest rates decline, stock prices may rise because equity cashflows become more valuable in comparison to bonds. Naturally other factors are in play too, but it’s the relationship between longer term bond yields and equities that should be our first stop when investigating the effect of rising interest rates.
The bond yield test
We can test how equities have fared against different interest rate environments by measuring their returns versus historical bond yield changes. If rising rates consistently hurt equities then we should find evidence for it in long-term bond yield moves that encompass booms, busts, wars, and every state in between. Our test compares annual bond yield changes against average annual equity returns across five major markets – the US, Germany, France, Italy, and Spain – reaching as far back as 1871. Critically, our results are real total returns that are reported in each country’s local currency. In other words, they include dividends, are inflation-adjusted, and don’t suffer from currency conversion issues. The real return aspect is especially important as rising yields regularly coincide with inflationary periods. There’s no point reporting high nominal returns if those superficially impressive figures are withered away by surging CPI rates. Let’s move on now to the results. It’s a mixed picture which indicates that investors are right to be wary – but not fearful – when yields rise quickly.Comparison: US, Germany, France, Italy, Spain
The US
Impact of yield changes on equities
| 1872 - 2020 | Yield down | Yield up |
|---|---|---|
| Number of years | 78 | 71 |
| Average annual equity return | 12.2% | 4.3% |
| Max. annual return | 60.9% | 39.9% |
| Min. annual return | -41% | -34.9% |
Source: justETF Research, 16.02.2023.
The split between years when yields rose or fell is fairly even as you can see in the table.
However, the average equity return when yields increase is much lower (4.3%) than the return when yields drop (12.2%). 12.2% is a fantastic average return but the good news is that 4.3% is well worth having, too. However, the maximum and minimum annual returns are particularly eye-opening.
US equities landed anywhere from 40% to -35% in years when yields increased. But, when yields slipped, the dispersion of returns was even greater: 61% to -41%. It’s hard to recommend yield changes as a ‘buy’ or ‘sell’ signal when the range of outcomes could lie anywhere from “awesome” to “abysmal”.
Indeed, drilling down into the maximum return years helps us uncover a deeper truth.
- The 61% return (‘Yield down’ column) was earned in 1933 after the terrible losses inflicted by the first leg of the Great Depression. Most investors would have been too terrified or broke to go anywhere near that market.
- Meanwhile, the 40% achieved in the ‘Yield up’ column came during 1928. That’s close to the top of the stock market bubble that ended in the 1929 Wall Street Crash.
Yield change magnitude: impact on US equities
| Quintile | Down most | Down | Mid | Up | Up most |
|---|---|---|---|---|---|
| Average annual equity return | 10.2% | 13.8% | 10.7% | 4.8% | 2.8% |
Source: justETF Research, 16.02.2023.
- ‘Down most’ captures the average return in the 20% of years when yields fell most steeply.
- The ‘Down’ column covers the years featuring the next steepest 20% of yield declines.
- The ‘Mid’ column reveals the average return for the mildest fluctuations regardless of their upward or downward path.
- Meanwhile the ‘Up’ and ‘Up Most’ columns show what happens when rises increase in severity.
Germany
Impact of yield changes on equities
| 1872 - 2020 | Yield down | Yield up |
|---|---|---|
| Number of years | 80 | 57 |
| Average annual equity return | 15.3% | 3.6% |
| Max. annual return | 136.1% | 102.3% |
| Min. annual return | -44.1% | -33.7% |
Source: justETF Research, 16.02.2023. Annual yields are flat in some years and there is no yield change data for 1922-24 and 1944-48.
German equity returns are clearly superior in years when yields are down versus up. However, the gap narrows when we examine average returns for the calendar year immediately following each yield change:
- The mean return for the year following a downward shift is 11%.
- The mean return for the year following an upward shift is 8.1%.
Yield change magnitude: impact on German equities
| Quintile | Down most | Down | Mid | Up | Up most |
|---|---|---|---|---|---|
| Average annual equity return | 26.2% | 12.7% | 1.4% | 4.1% | 2.6% |
Source: justETF Research, 16.02.2023.
In the German case, the best returns are heavily skewed towards big yield drops. (Remember the ‘Down most’ column only ranked third in the US dataset).
However, the worst returns occur in the middle column - and not the right-hand column as theory would lead us to believe.France
Impact of yield changes on equities
| 1872 - 2020 | Yield down | Yield up |
|---|---|---|
| Number of years | 89 | 59 |
| Average annual equity return | 8.6% | -4.5% |
| Max. annual return | 115.9% | 36.6% |
| Min. annual return | -46.1% | -45.4% |
Source: justETF Research, 16.02.2023. Annual yields are flat in some years.
The French experience is much more negative when yields climb. High inflation rates that forced up yields in the post-war years are a significant factor here.
This effect is also pronounced in the higher resolution table …
Yield change magnitude: impact on French equities
| Quintile | Down most | Down | Mid | Up | Up most |
|---|---|---|---|---|---|
| Average annual equity return | 16.1% | 7.1% | 2.7% | -1.1% | -7.8% |
Source: justETF Research, 16.02.2023.
French results match theory perfectly. Returns decline monotonically left to right as yield rises get steeper. French equities also differ from German and American because average real returns are not always positive.
Indeed, that -7.8% result is the worst except for Italian stocks …Italy
Impact of yield changes on equities
| 1872 - 2020 | Yield down | Yield up |
|---|---|---|
| Number of years | 70 | 79 |
| Average annual equity return | 13.6% | -1.6% |
| Max. annual return | 120.5% | 51.6% |
| Min. annual return | -72.9% | -54.5% |
Source: justETF Research, 16.02.2023. Annual yields are flat in some years.
Italian returns are also negative on average when yields rise, and exhibit a strong positive bias when yields retreat. Once again, the gap closes somewhat when the next year’s returns are analysed, though the differential is still large:
- The mean return for the year following a downward shift in yield is 9.1%.
- The mean return for the year following an upward shift in yield is 1.9%.
Yield change magnitude: impact on Italian equities
| Quintile | Down most | Down | Mid | Up | Up most |
|---|---|---|---|---|---|
| Average annual equity return | 18.1% | 8.3% | 8.9% | 1.1% | -7.9% |
Source: justETF Research, 16.02.2023.
Italian equities send a clear signal when rate rises are extreme. But the middle ground is muddier. The second best average returns (8.9%) occur when yields fluctuate gently in either direction.Spain
Impact of yield changes on equities
| 1872 - 2020 | Yield down | Yield up |
|---|---|---|
| Number of years | 63 | 52 |
| Average annual equity return | 12.5% | -1.9% |
| Max. annual return | 96% | 41.1% |
| Min. annual return | -22.9% | -42.8% |
Source: justETF Research, 16.02.2023. Annual yields are flat in some years and there is no yield change data for 1937-1940.
The Spanish average return experience is very similar to the Italian - splitting mildly negative and strongly positive when yields rose or fell respectively.
Again the effect starts to wear off 12-months down the line:
- The mean return for the year following a downward shift in yield is 9.6%.
- The mean return for the year following an upward shift in yield is 2%.
Yield change magnitude: impact on Spanish equities
| Quintile | Down most | Down | Mid | Up | Up most |
|---|---|---|---|---|---|
| Average annual equity return | 18.7% | 6.3% | 8.2% | -0.4% | -3.4% |
Source: justETF Research, 16.02.2023.
The Spanish market also shows that stocks are adversely affected by high rate rises. But the strong returns in the centre ground reveal that moderate upward movements in yields are not harmful.The yield change takeaway
So what can we conclude from these mixed signals? Firstly we can say that conventional wisdom is on to something: rising interest rates do tend to dampen stock returns in the short-term. However, this is not always the case as much depends on the rapidity of the yield change. Indeed, rising yields may indicate that economic demand is booming and the outlook for future stock returns is positive. But sharply rising rates are likely to be bad news for equities in the moment. That’s why the fast and jolting rises of 2022 equated to a rough year for our investments. But equity returns are inherently too unpredictable to be reduced to a single trading signal. It’s not enough to see that interest rates are rising. To profit from that knowledge, you must also be able to predict their future path plus their Second-Order effects upon the economy, inflation, and the reactions of other investors. This is a near-impossible task to do consistently. That’s why Warren Buffett believes we should invest for the long-term and forget the market noise. Yes, if rates continue to rise sharply due to uncontrolled inflation (as per the 1970s) then we will face some difficult times. However, there are already signs inflation has peaked as energy prices abate and wage claims fail to keep up with the rising cost of living. While the future is unpredictable we do know that inflation is eroding cash in the bank as assuredly as it hurts other assets. The difference is that equities are almost certain to outperform other assets over time. Granted, equity ETFs will not win every year. But in the long-term they are the surest route to increasing your wealth. Finally, it’s worth remembering that what other investors do matters. If market participants abandon equities en-masse (perhaps because interest rates are rising fast) then stocks will become cheap relative to their fundamental value. At that moment of seeming misfortune often lies the greatest opportunity to make outsized profits. The maximum real returns revealed in the tables above (sometimes over 100%) came during the darkest days when equities looked down and out. That’s why it’s better to keep investing even during turbulent periods. Cost averaging is a great technique that helps you do just that. This article was inspired by Andrew L. Berkin’s study What Happens to Stocks When Interest Rates Rise?, which appears in The Journal of Investing.justETF tip: Rising interest rates do hurt bonds in the short-term before improved yields contribute to greater returns in the longer term. This piece explains how that market mechanism works. Consider investing in shorter-term bonds on the defensive side of your portfolio if you’re convinced rising interest rates are here to stay awhile.
