Han Dieperink: Interest rates and share prices are rising in tandem
This column was originally written in Dutch. This is an English translation.
By Han Dieperink, written in a personal capacity
The US 10-year yield is a full percentage point higher this year. Last week, it reached 5.23 per cent. Over the same period, the S&P 500 rose by over 10 per cent. In theory, these figures do not add up.
Higher interest rates make bonds more attractive. Furthermore, investors discount future profits, based on higher interest rates, back to the present. This reduces the value of shares. Anyone who had seen these two figures on 1 January would therefore have expected a much weaker stock market. The opposite happened. The price-to-earnings ratio, based on expected profits, fell by around 15 per cent. Shares rose, but at the same time became cheaper.
The value of a share is the expected dividend divided by the difference between the yield demanded by investors and the growth rate of that dividend. If interest rates rise, the denominator increases and the value falls. But growth is also factored into the denominator, with a negative sign. If growth rises, the denominator decreases and the value rises. It is therefore not just about interest rates, but about the difference between interest rates and growth.
Earnings growth is remarkably strong worldwide. In the United States, the earnings of the median share have grown by 35 per cent over the course of a year. The number of upward earnings revisions is comparable to the recovery following a recession. Europe is experiencing its best earnings season in years, with expected earnings growth of around 20 per cent for 2026. In Asia and the emerging markets, far more companies exceeded expectations than fell short of them. Moreover, growth is becoming more widespread than just AI. Earnings for the equally-weighted S&P 500 are also accelerating. As a result, the risk premium has barely changed. Share prices rose, but earnings rose faster. It is not higher valuations, but higher earnings that are driving the stock market.
An interest rate that reflects growth
An interest rate rise has two phases. As early as 1898, the Swedish economist Knut Wicksell provided the key to distinguishing between them. He drew a distinction between the market rate and the natural rate. The natural rate is the rate at which saving and investment are in balance and prices remain stable.
In the first phase, the market rate rises in line with a stronger economy, which also pushes the natural rate higher. As long as the market rate does not exceed the natural rate, it does not slow down growth.
In the second phase, the market interest rate rises above the natural rate. Borrowing then becomes so expensive that the economy begins to slow down. For investors, the question is therefore not only how high the interest rate is, but above all how far it lies from the natural rate.
The composition of the rise in interest rates provides an important clue. Since early September, inflation expectations have actually fallen. The rise is therefore mainly driven by the real interest rate. On US inflation-linked bonds, this currently stands at 2.7 per cent. That may seem high, but it is consistent with an economy that, according to the latest GDP Now estimates, is growing at an annual rate of 5 per cent. The two-year inflation expectation remains stable at around 2 to 2.2 per cent, and core inflation has fallen to 2.4 per cent. Interest rates are therefore rising due to economic strength, not fears of inflation.
Keep an eye on the yield curve
The best indicator of the turning point is the yield curve. It has already flattened by 40 basis points this year. There are still 20 to 30 basis points to go before short-term interest rates exceed long-term rates. In the past, an inverted curve has often been accompanied by falling share prices, a rising VIX and sometimes even a recession.
The market is now pricing in four further interest rate rises by the Federal Reserve, amounting to around one percentage point through to 2027. That is probably too much. Such a policy rate would be appropriate for 2022, when core inflation was above 5 per cent and nominal growth stood at 10 per cent. Inflation and nominal growth are now roughly half that level. Rising productivity is putting downward pressure on inflation, but at the same time a series of supply shocks is keeping it high. For example, the sharp rise in diesel prices may gradually feed through into producer prices. In the short term, therefore, energy is driving interest rate expectations. In the longer term, it is a question of productivity.
Higher interest rates can also have a direct impact on shares: investors sell shares and buy bonds. There is little sign of this happening, however. Inflows are positive for both shares and bonds. Foreign investors, too, continue to buy US bonds and shares in significant quantities. Up to and including August, US companies with high credit ratings issued $1.6 trillion worth of bonds, 30 per cent more than last year. The major cloud companies have already borrowed more than $220 billion this year. With a price-to-earnings ratio of over 20, borrowing at 6 per cent is cheaper for them.
The budget deficit is not to blame
Many investors attribute the rise in interest rates to the US budget deficit. It is therefore strange that interest rates are rising worldwide, including outside the US. Around half of the deficit, which stands at 5.6 per cent of GDP, is financed by a private-sector savings surplus of 2.7 per cent. The rest comes from abroad.
If that surplus is not spent by the government, the economy contracts. A large deficit is therefore primarily the flip side of high savings. If confidence in US public finances were to truly collapse, the dollar would first fall sharply, but it remains strong. The rise in interest rates is being driven by a normalisation of rates, following a decade of debt reduction, asset purchase programmes, zero or even negative interest rates, and fears of deflation. That normalisation is likely largely behind us.
The bar has been raised
Profits must continue to grow strongly. Companies that lower their profit forecasts are being punished ever more severely. You should therefore opt for companies with the strongest profit growth. An additional advantage is that the premium on quality shares has fallen sharply in recent years. Once interest rates reach their peak, shares will benefit twice over: from growing profits and from a recovery in valuations. Interest rates and share prices can therefore very well rise together. As long as the numerator grows faster than the denominator, the stock market will continue to gain.