Can equities absorb higher interest rates?

The US bond market appears to be pricing in strong economic data and GDP gains ahead, driven by increased consumer and business activity, and further pushed by more expected government stimulus. . Consequently, the US 10-yr treasury yield has risen to above 1.3%. In India too, we have seen the 10-yr yield rising above 6%. This rise in yields is leading to some nervousness amongst market participants which has led to a near term correction both globally and in India. During the taper tantrum in 2013, global and Indian equity markets had seen a sharp correction when yields rose sharply by 130 bps when the US Fed announced a roadmap for a faster-than-expected increase in interest rates.

This time it’s different

However, the taper tantrum in 2013 was in an environment of slowing growth, especially in China whereas the global economy is firing on all cylinders at this time. Also, current moderate rise in inflation is being driven by supply side due to the reflation in economy with low interest rate and high liquidity.

It’s only when policy makers start hiking rates aggressively that the stock market typically reacts negatively. In that context, the US Fed has reiterated that they will maintain their accommodative policy till the end of 2024. This could be pulled forward and we could see a rate hike in the middle of the next year if growth and inflation are higher than expected. However, interest rates will still remain well below historical levels and for the market to peak out, rates need to reach much higher levels. For example, during the market peak in 2007, US interest rates were near 5% and in 2018, they were above 3%.

Equity rally to continue

As long as a gradual increase in yields is driven by growth and moderate inflation, stocks should be able to absorb higher rates amidst strong earnings. We are in the early stages of an economic recovery and monetary and fiscal policy too remain supportive. Also, the earnings rebound has been sharp and relative valuations are still favourable. Given this, we maintain our overweight stance on equities.

The writer is Co-CIO, Aditya Birla Sun Life AMC Limited