It was only a little over two years ago when a 25 basis-point interest-rate hike by the U.S. Federal Reserve (Fed) sent the 10-year U.S. Treasury yield to 1.45%. Deflationary fears gripped the markets and investors bemoaned the inability of the financial markets to wean themselves off monetary stimulus. Would we ever again see a day when the Fed Funds Rate could go above 2%? Could 10-year rates ever remain above 3%?

Fast forward to yesterday’s “market rout.” The backdrop of higher real rates, hawkish Fed talk, and the sell-off in long duration assets – including long-term bonds and technology stocks – may have equity investors thinking that they need to be more careful about what they wish for. In my view, the reality is that higher rates reflect improved real economic activity in the United States and will not, at these levels, kill the ongoing bull market.

Below, we address a series of questions regarding higher rates and the implications for global financial markets.

1. How does the recent interest rate move compare with prior moves?

The recent increase in the 10-year U.S. Treasury rate is, from the cyclical trough to the peak (or in this case the current level), already the third largest since 1990. Cyclically, there is a good case for higher rates. U.S. economic growth is strong, consumer and business sentiment is robust, and the U.S. Federal Reserve (Fed) is shrinking its balance sheet.

Exhibit 1: 10-Year U.S. Treasury Rate Trough to Peak Increase (1990-2018)

2. Is this really all about real economic activity? What about inflation?

The driver of rates, to this point, is stronger real economic activity and not a change in inflation expectations. As Exhibit 2 shows, the spike in Treasury yields this year has come predominantly from higher real yields. Importantly, inflation break-evens [the spread between the rates of 10-year U.S. Treasury and the 10-year U.S. Treasury Inflation Protected Securities (TIPS)] have been range bound while 10-year TIPS (real) yields have broken out to the highest levels in seven years.

Exhibit 2: The Move in Rates Has Been from Higher Yields, Not Inflation Fears

3. When will inflation begin to accelerate?

The U.S. job market is already very tight. The number of job openings is outpacing hiring by a wide margin. Yet, average hourly earnings growth remains relatively low, as does aggregate inflation. There are structural factors that are likely to continue to suppress inflation including, but not limited to, globalisation, technological advancements, and aging developed-world populations.

Exhibit 3

4. What do higher long rates mean for Fed policy?

The consensus among economists and market analysts is that the Fed will again raise rates in December. The market is also pricing in three to four interest rate hikes next year, taking the range of the Fed Funds Rate to 3.25%-3.50%. The policymaking Federal Open Market Committee’s (FOMC) median projection for the Fed Funds Rate in 2020 and 2021 is 3.375%, suggesting that the end of the tightening cycle is in sight. The median expectation is no rate hikes beyond 2019, barring a significant acceleration in economic activity and inflation, and a coincident steepening of the U.S. Treasury yield curve. The yield curve has steepened modestly since late August but is significantly flatter than it was at the start of the year.

Exhibit 4: U.S. Treasury Yield Curve: 10-Year Munis 2-Year U.S. Treasury Rate

5.  Are U.S. stocks still cheap relative to U.S. Treasuries?

Yes, although stocks are not nearly as cheap relative to bonds as they were in the years following the 2008 financial crisis. Nonetheless, the S&P 500 Index’s earning yield remains greater than the yield of the 10-year U.S. Treasury.

Exhibit 5: S&P 500 Index Earnings Yield Minus 10-Year Treasury Rate

6. Will the cyclical rise in rates kill the bull market?

I’m skeptical that rising rates will kill the bull market, but I will be closely watching U.S. financial conditions, credit spreads, and the U.S. dollar. Neither financial conditions nor credit spreads are at worrisome levels. Financial conditions have tightened modestly in the past weeks but, even with the Fed’s hawkish stance, remain easy from a historical perspective. In addition, high-yield credit spreads widened last week but remain historically tight. The U.S. dollar has been stubbornly strong and could prove a headwind to U.S. growth in 2019, particularly if trade relations with China deteriorate further.

Exhibit 6: Goldman Sachs Financial Conditions Index

7. At what level do interest rates weigh on equity valuations?

Even as the fundamentals of the economy remain sound, there is a rate level that would put pressure on sentiment and drive valuations lower. Historically, valuations have compressed once interest rates hit 5% for a sustained period. With rates currently so low, that threshold may be closer to 3.5%-4.0% on a sustained basis.

It is important to note that:

A) Earnings growth can do much of the heavy lifting for equities even if multiples contract, and

B) Equity valuation compression will depend on many factors beyond the nominal rate, including the trajectory of the economy, the pace of Fed rate hikes, and the shape of the yield curve.

Exhibit 7: Interest Rates and Equity Valuations

8. Are there certain sectors of the equity market that typically outperform during periods of rising interest rates?

Cyclical sectors, including information technology, industrials, financials, and materials tend to outperform during periods of rising interest rates, while defensive sectors such as utilities, telecom, and real estate generally underperform. The chart below shows that the ratio of the cyclical index to the defensive index tends to increase during periods when rates are rising (shaded gray).

Exhibit 8: S&P 500 Cyclical Sectors/S&P 500 Defensive Sectors

9. What do rising rates mean for non-U.S. investments?

Rising long-term interest rates historically have been beneficial to most asset classes. Rate increases typically coincide with improvements in economic activity, benefiting equities and equity-like assets globally as well as credit.

For now, investor concern about trade and Fed policy limit the likelihood of a significant rotation into emerging market equities. However, emerging market growth prospects are likely to improve relative to the U.S. over the intermediate term as the Fed tightens conditions and China and India continue with more stimulative monetary policy. That will ultimately favour emerging markets over domestically focused U.S. companies, particularly given current relative valuations.

Exhibit 9: Asset Class Performance Rising Rates

10. Do we still believe interest rates will remain low for long?

Yes. Exhibit 10 shows structural declines in interest rates across select developed economies as the country’s age dependency ratio worsens. Rates in the U.S. will likely follow a similar pattern over the coming decades as the population ages.

Exhibit 10: Age Dependency Ratio and Interest Rates (1992-2017)