Indiana Trust Wealth Management
Investment Advisory Services

by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services

  • The US equity market, represented by the S&P 500 index, slipped 0.7% for the week ending September 29.
  • How do higher interest rates impact expected long-term returns for stocks?

When interest rates rise, bond prices fall. This is how the time value of money works. Higher rates increase the cost of waiting for future interest and principal payments, so they are worth less today. Future cash flows from bonds are certain, and for those from the US Treasury, they are risk-free. Changes in interest rates mechanically change bond prices.

The decrease in the price of bonds is part of its total return. So, contemporaneous returns on bonds are hampered by rising interest rates. This has certainly been proven out over the last two years. What do higher interest rates mean for expected returns on bonds, over the next five to seven years, at the current point in time? They are a good thing. Yields are now higher.

Higher interest rates impact the price of any financial asset generating future cash flows, such as stocks, as those future cash flows are also impacted by the time value of money principle. Higher rates were blamed for some of the selloff in stocks in 2022, particularly for the carnage in growth-stocks and tech names. That is, contemporaneous returns for stocks were hurt by the rise in rates.

What do now-higher interest rates mean for expected long-term returns on stocks? The “equity risk premium” is the premium investors demand for investing in risky stocks above the yield of boring, safe US Treasury bonds. As we have noted ad nauseum, bond yields have gone up. What about the equity risk premium?

Professor Aswath Damodaran at NYU is legendary for his attention to the equity risk premium. He has written that historically the premium has been about 5% in the US, that is, stocks have returned about 5% above long-term Treasury bonds.

But the professor takes perhaps a better approach to figuring out the premium: what is the implied equity risk premium today, based upon the current market price, the current long-term US Treasury bond yield, and earnings growth expectations? His most recent calculation is that the implied equity risk premium is 4.9%. Adding the current 10-year Treasury note yield of 4.6%, the expected return for stocks is over 9%.

That does not mean stocks will necessarily return 9%. Model inputs such as earnings growth are projections. Historically, however, there is a positive relationship between starting bond yield levels and total returns on stocks over the subsequent five years.

A question that investors are debating is whether the equity market has fully re-priced given higher interest rates or whether more rate-driven equity pain is ahead. Markets are not fully efficient, but the US Treasury bond yield curve is not a secret to stock market investors. Assuming that interest rates are near their high-water mark for this rate cycle, which is the consensus view, it doesn’t seem logical that more stock market pain attributable to higher interest rates is ahead.


IMPORTANT DISCLOSURES: All info contained herein is solely for general informational purposes. It does not take into account all the circumstances of each investor and is not to be construed as legal, accounting, investment, or other professional advice. The author(s) and publisher, accordingly, assume no liability whatsoever in connection with the use of this material or action taken in reliance thereon. All reasonable efforts have been made to ensure this material is correct at the time of publication.  Copyright Indiana Trust Wealth Management 2023.