Market participants instinctively grow nervous when interest rates rise. Rates have always been at the center of past episodes in which asset price bubbles deflated. The 12-month forward price-to-earnings ratio for the U.S. S&P 500 stands at 19 to 20 times. That implies a long-term expected return of 5% for the stock market, the inverse of the P/E ratio. When the U.S. 10-year Treasury yield rises above 5%, equities lose that much of their appeal.
Causality in financial markets is complex. It is worth considering the possibility that bubbles did not burst because central banks raised rates, but rather that rates climbed by momentum as bubbles peaked and collapsed. If asset prices crumbled because debt had piled up beyond what the system could bear, rising rates were not the cause of the collapse but another of its consequences.
It is also difficult to compare past rate-hike cycles directly with the present. Artificial intelligence now accounts for a larger share of economic growth and capital spending, so the traditional transmission channels of rate increases may not work as they once did. The rise in long-term yields across major economies likely stems more from concerns over fiscal soundness than from AI investment.
For now, high rates, AI investment and a rising stock market still appear able to coexist. First, the threshold level for rates may have moved higher than in the past. Looking at the U.S. 10-year Treasury yield and the S&P 500's 12-month forward P/E since 1990, downward pressure on valuations intensified not at 5% but once yields reached 5.5% to 6.0%.
More important are expectations for earnings growth. When corporate earnings growth exceeds the historical average of 13.5% since 1990, the positive relationship between earnings growth and P/E ratios becomes clearer. If U.S. corporate earnings grow 20% or more, a market P/E of 20 times can be justified even with the 10-year Treasury yield above 5%.
Profit margins at companies in major economies are also higher than before the COVID-19 pandemic. Even if margins pass their peak and slow, that does not immediately end the stock market's advance. As long as corporate profit margins improve faster than rates rise, the market will withstand the pressure of high rates.
Not all asset prices and share prices can rise, however. The higher rates go, the narrower the range of gaining stocks becomes, and large-cap blue chips with strong balance sheets are likely to hold a relative advantage. In South Korea, that points to sectors profitable enough to offset the burden of higher rates while carrying light valuations — semiconductors, securities, shipbuilding and energy. Semiconductors, which have brought domestic investors both joy and worry, may prove the safer choice in a rising-rate environment.
