The Interplay Between Interest Rates, Inflation and Equity Returns

Investing in the equity market is both an art and a science. There are many macro and micro variables, along with collective investor sentiment, that determine equity market performance. Inflation and interest rates are two such key macro variables. Determining this correlation is important for portfolio construction, sector allocation and risk management.

Fundamental relationship between inflation, interest rates and equity market

At the heart of equity valuation lies the discounted cash flow (DCF) framework. Future cash flows are discounted at an appropriate rate to derive the present value. That discount rate is a function of the risk-free rate, which in turn is anchored to prevailing interest rates.

When central banks raise rates, discount rates rise, compressing the present value of future earnings, particularly for companies whose cash flows lie far in the future. This leads to price-to-earnings multiple compression. On the other hand, rate cuts by central banks are positive for equity market valuation.

Inflation complicates this picture, it influences nominal interest rates (central banks raise rates to fight inflation) and corporate earnings (by raising input costs and eroding consumer purchasing power). The net effect on equity depends critically on the type of inflation and the speed of the policy response.

Let us look at historical data to better understand this complex relationship. Given longer and more comparable datasets, US and global developed markets data have been presented.

Equity performance in different inflation regimes

Traditionally, equity is considered the perfect long-term hedge against inflation. However, not all inflation is equal. A study published in Financial Analyst Journal in 2023 titled ‘Investing in deflation, inflation and stagflation regimes’ over 1875 to 2021 reveals a clear pattern, moderate inflation (0-4 per cent) is the sweet spot for equities (see Figure 1 below), while very high inflation is destructive to real returns and deflationary periods are associated with sub-par equity returns.

Figure 1: Equity performance in different inflation regimes

# Inflation data for the United States, the United Kingdom, Germany, France and Japan. Equity returns are for MSCI World Index in USD.
Note: The returns are per annum
Source: ‘Investing in deflation, inflation and stagflation regimes’ by Guido Baltussen, Laurens Swinkels, Bart van Vliet and Pim van Vliet

Rate cycle and equity markets
Monetary policy cycles have historically been among the strongest short-to-medium-term drivers of equity market performance. The decade-long era of near-zero interest rates following the 2008 Global Financial Crisis created an exceptionally accommodative backdrop for equities, inflating valuations across the board.

The 2022 tightening cycle provides a textbook case study. The US Federal Reserve delivered 425 basis points of rate hikes in a single year, the most aggressive tightening in four decades in response to spiralling inflation. The S&P 500 fell sharply that year (see Figure 2 below).

Figure 2: Change in US Fed’s interest rate regime has had material near-term implications for US equity markets

Source: Bloomberg. US Fed rates are average for the respective years

Not a straightforward relationship, context matters

While the above discussion explains the theoretical relationship between these variables, in the real world, the interplay between these three forces is neither linear nor static. The regime matters, whether inflation is driven by demand (generally equity-friendly if managed well) or supply shocks (like the one the world is facing currently), whether central banks are ahead of or behind the curve in increasing or cutting rates, and whether the rate cycle is at its beginning or end. Hence, the context becomes very important. The table below presents some scenarios to better understand the context and the likely implication for equity markets.

Disclaimer: The opinions expressed above are of the author and may not reflect the views of DSIJ.