Can we buy Kwality shares right now?

What happens to stocks when interest rates rise?

There is no doubt that stocks have benefited from falling or low interest rates in the past. In addition to the development of corporate profits, the interest rate level is actually a key price driver for dividend securities.

One thing is clear: if (corporate) profits rise, the price of shares usually also rises. In the case of interest, the influence is reversed. The higher the interest rate, the lower shares are valued. This is the case because investors prefer a secure return to a risky investment. In the recent past there have been next to no safe returns. Investors were thus “forced” to take risk if they wanted to generate increases in value. That is why there was more investment in stocks.

Will the upward trend soon be at its peak?

The interest rate level is influenced, among other things, by inflation. Deflation, which was still on our minds in 2015, is not an issue at the moment. The central banks have therefore started to “normalize” their very loose monetary policy again. This return to normal makes some equity investors speculate about whether the uptrend will soon peak?

Inflation (in the USA) back to 2% - currently no risk of deflation

Fig. 1, source: Datastream

Figure 1 shows: In the past two years, inflation has risen from a negative range back to a “normal” level of around 2%. Despite rising inflation, the stock markets have continued their upward trend over the past two years. The rating has even tended to rise.

Does that mean that rising inflation will no longer affect the valuation of stocks? The following chart should provide clarity on this question:

Connection between rising inflation and decreasing valuation level

Fig. 2, source: MSCI, Datastream

Fig. 2 illustrates the relationship between inflation and valuation level (price-to-book ratio for the US market as a whole). The blue bar represents the valuation ranges over the last 40 years for US companies. The following actually applies: the higher the inflation, the lower the valuation on the stock markets (considering the mean values). However, this relationship only applies to inflation levels above 3%. The highest valuation levels have been observed in the past around inflation around 2%. If inflation falls well below 2%, the relationship described above no longer applies: falling inflation below 2% does not mean a higher valuation, but - on the contrary - the valuation begins to fall again. This phenomenon has been observed in Japan. Because many companies find it difficult to increase their profits in a deflationary environment.

The “magic” 3% inflation threshold

Equity markets have tended to benefit from inflation over the past two years as the specter of deflation has been pushed into the background. Rising inflation in the range between zero and two percent usually goes hand in hand with a higher valuation. We are currently in a "sweet spot", i.e. the valuation is highest when inflation fluctuates around two percent. There is only danger when inflation rises above three percent. We do not currently see this danger.

In the event of a significant rise in bond yields, a correction threatens

If - contrary to expectations - inflation continues to rise and the associated yields on government bonds rise significantly, it is to be expected that the stock markets will actually react with a lower valuation. A correction or stagnation is then very likely. Increasing profits can only partially offset this effect.

Value stocks with bonds rising - yields

Investors who assume this scenario and expect significantly increasing returns, but still want to invest in stocks, should concentrate more on value stocks - as opposed to quality stocks. Value stocks cannot necessarily be equated with “undervalued”. They only have a low valuation in terms of price-earnings ratio (P / E) or price-to-book value (P / E) ratio.

What are value stocks anyway?

Currently, it is mainly shares in financial stocks (banks, insurance companies) and raw materials companies. Bank stocks benefit from a steep yield curve, i. H. Significantly higher interest rates for longer terms than for shorter ones. The earnings of commodity stocks should benefit disproportionately from rising inflation. The focus on value stocks should remain in place until the first signs of a recession appear. Then quality shares, the papers of stable and financially strong companies, should get the upper hand again.

Fig. 3 shows the relationship between the outperformance of value stocks and the development of the yields of 10-year US government bonds. The connection can be seen with the naked eye. If yields rise, value stocks (especially financial stocks and commodities stocks) will outperform the entire stock market. If bond yields actually continue to rise, the persistent underperformance of value stocks since the financial crisis could come to an end.

Fig. 3, source: Bloomberg, MSCI
Note: no fees or taxes are taken into account in the performance. Past performance does not allow any conclusions to be drawn about future developments.

 

Important legal information:

Forecasts are not a reliable indicator of future developments.