As the economic recovery gains stronger footing in the aftermath of COVID-19, the relationship between stocks and bonds provides ample historical evidence of what may come next. Although the possibility for short-term equity market volatility is always present, the long-term approach to participating across capital markets is one that favors stocks. The relationship is quite simple: yields gain upside during times of recovery and economic strength. As yields rise, bond prices fall, which is a testament to their negatively correlated relationship. Amidst such a simple relationship, however, historical data also reveals the benefits of investing in stocks during periods where the 10 year-yield gradually makes its way to higher levels. This becomes dominantly more opportunistic when the 10-year-yield remains in low territory, as is the case right now. It may be difficult to envision a yield above 3%, but that is not something we should discount over the next two years. Stocks may stand to benefit relative to bonds.
The reality of interest rates is simple, despite the on-going rhetoric that attempts to overcomplicate its narrative. If the expectation for economic growth is that it will notably surpass pre-COVID levels, and sustain a trend thereafter, then interest rates are headed higher. The Federal Reserve’s dovish stance to maintain interest rates near zero has started to appropriately fizzle and there remains no meaningful basis to assume market driven interest rates need to remain low. The observed fact that the Fed does not directly control the 10-year yield, nor does it directly control borrowing costs for consumers (i.e., mortgages, car loans, personal loans,…etc.) is an important consideration in the current demand heavy environment. From an observed historical basis, the argument for higher interest rates during an economic recovery provides tangible evidence that we can use. Yields rise, or fall, based on the pace of GDP (Gross Domestic Product) growth. This is a healthy occurrence that allows the economy to substantiate higher borrowing costs amidst an environment of strong consumption demand, ample private job creation, and [most likely] a robust global equity market. Although less accommodative monetary policy may generate a minor short-term shock factor to equity markets, we remain in favor of aggregate exposures within sectors and equities that maintain relatively attractive valuations alongside strong cash flow metrics. The added uncertainty from further COVID variants may be the norm over the next 12 months and we would argue that added risk within portfolios for investors rests more so within fixed income assets rather than equity assets. All of this is to suggest that we should not be fearful, nor complacent, at the fact that interest rates may look drastically different 12 months from now.
