stocks vs. bonds when interest rates are rising (ii)

yesterday’s post: bonds

To summarize yesterday’s post, when interest rates are rising, newly-issued bonds bear higher coupons than ones issued in the recent past. Older bonds look less attractive, because they provide less return.  So they have to go down in price until they’re trading at equivalent returns to new ones.

Other than inflation-indexed bonds, Treasuries have no defense against this.

What about stocks?

Here the issue is a bit more complicated.

Let’s make the useful, and more or less correct, assumption that stocks and bonds are in equilibrium before rates start to rise.  If so, if bonds get cheaper, stocks will also have to get cheaper in order to compete for investor money against now-higher-yielding bonds.

This means rising rates puts downward pressure on stocks, too.

But stocks do have a defense.  It has to do with why rates are rising.

In most cases, rates begin to rise when either bond investors or the Fed sense incipient inflation that threatens to erode the purchasing power of money.  This is what triggers the impulse to raise rates.  Since in advanced economies, inflation is always an issue of wage inflation, its early warning signs are that the economy is reaching full employment and/or wages are beginning to rise at an accelerating rate.  In the US, that’s where we are now.

But more workers employed and wages rising at a healthy clip imply that consumer spending is likely to rise at an accelerating rate.  This implies accelerating profit growth for, in sequence, retailers, their suppliers and the providers of capital goods to both retailers and suppliers.  To the extent that a given stock market represents the local economy (which about half of the S&P 500 does), profits of publicly traded companies will start to go up at an unexpectedly sharp rate.

Rising profits create upward pressure on stock prices that serves as at least a partial counter to the downward pressure created by rising rates.


A second issue that will affect stocks directly is how the combination of inflation and higher rates affects the local currency.

If the currency falls, which is the most common case, export-oriented or import-competing companies will have the best results.  Purely domestic firms, and domestic firms that use foreign inputs, will fare relatively poorly.

If the currency rises, the opposite will most likely happen.

the S&P 500 in past times of rising rates

In the US in the past, the upward pressure from rising profits and the downward pressure from rising interest rates have most often neutralized each other.  There have certainly been diverse sector and industry performances, based on currency, technology, government fiscal policy and the overall state of the world economy.  So there have typically been substantial outperformance opportunities even in a sideways market.  But the overall market tendency in the early year or so of rising rates has typically been sideways, not down.


Tomorrow, REITs.



3 responses

  1. I think my lesson learned is ask a stupid question, you get a worthy answer.

    (You can’t see it right now, but I am bowing right now).

    The more granular aspect of Vornado is of course the owner, Steven Roth, who is a very good friend of Trump’s.

    Kleptocracy in the US has been going on a long time (Aaron Burr? Nelson Aldrich? Clinton Foundation?) but it is usually being the scenes enough to be decorous. I doubt that is the case going forward.

    I’ve been reading their investor presentations. Vornado/ Charles E Smith is not contributing the Skyline (Alexandria, Virginia) properties; they are a real dog. JPG is not contributing about $3B with of stuff — they summarize it as condos, highly leveraged properties, and properties not served by Metro stations.

    There are two big real estate deals in play. The FBI HQ, which has been part of a GSA process but may change. Basically GSA wants to swap the FBI HQ with another property to get outside Congressional republicans. That may not be necessary.

    The Department of Labor also needs to move and has a huge building downtown.

  2. Thanks for your comment. The short response to your question last week is that I don’t know much about Vornado, although at one time I knew JBG relatively well. In theory, the creation of separate securities offering NYC and Washington, DC real estate should increase the price of the total package. So that’s good. On the other hand, one very big attraction of Washington real estate is that government–including its camp followers–never gets smaller, it always gets bigger. Is there any chance that a Republican administration would get it into its head to try to trim some of the fat?

  3. When Republicans talk about “fat” trimming, what they are really saying is “Trimming the fat in programs that we don’t like”.

    Any sort of relaxation on hiring freezing, sequestration, or military budgets would be good from the DC CRE market, which is one the worst performing in the last 4 years.

    If you remember JBG, you might remember the competition — Charles E Smith — which is what Vornado bought. Again mostly their holdings are in the Crystal City area. (By national airpot, virginia side) This was all 30+ year old buildings that were leased to various Pentagon agencies. BRAC forced them to move, and they have been pretty empty since then.

    Vornado seems to be known here more as a pump and dump operation (vs. JBG). So the narrative is with better JBG management the Crystal city properties can shine. Hence that magic word growth which you use in the third REIT post.

    (In reality, Vornado has been pretty good as a landlord there, and the issue is you need to rebuild those old buildings before tenants look at them.)

    The new entity (JBG-CES) will of course be run by Steven Roth, Trump’s business partner is dismantling Alexander’s.

    Pretty depressed today, my little refinery that could (NTI) that got bought by WNR (still a very decent 5% yield) now is part of Tesaro, which is horrible. I hate mergers.

Leave a Reply

%d bloggers like this: