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Global Allocation Insight

The effect of rates on markets today

September 30, 2019

Investors expect stocks to rise when rates decline, but at rates this low, that might not be the case.

A stronger U.S. stock market is no longer news, but what is interesting was that in early September stocks rose even as interest rates surged higher. Although lower rates have historically supported stock market rallies, we believe at these low levels, modestly higher rates don’t threaten stock valuations, especially if the move higher is driven by firmer economic expectations.

The conventional wisdom is that lower interest rates are good for stocks. This follows from basic economic theory: the lower the discount rate of future cash flows, the higher the present value of an asset. Over the long term, this relationship is evident in the data. As illustrated in the chart, investors have typically paid more for stocks (in the form of higher price-to-earnings (P/E) multiples) when rates are lower.

Stock valuations usually rise when rates fall
Relationship between S&P 500 Index P/E ratios and 10-year Treasury yields

Stock valuations usually rise when rates fall

Source: Bloomberg, month-end data Jan 1960 - Aug 2019. S&P 500 Index price-to-equity ratio trailing 12 months.

There is a caveat, however. The relationship between yields and P/E multiples become less correlated when rates get very low (below ~5%), as they have been for more than a decade. A simple explanation is that when extremely low interest rates are associated with recession fears, as we saw in 2009 and 2012, stock valuations are generally lower.

There have been some positive signals for the U.S. economy of late, notably solid consumer data, and it appears that both China and the U.S. are looking to de-escalate the trade conflict. However, the majority of global economic indicators are still showing signs of softening. At the current low levels of interest rates, if rates were to fall as a result of another round of poor global economic data, it may not provide the boost to stock valuations investors have come to expect.

The BlackRock Global Allocation Fund is positioned to reflect our view that the global economic backdrop remains fairly stable, albeit expanding at a slower pace. In this low-rate environment, we believe the better opportunities reside in high quality stocks tied to secular growth themes, U.S. Treasuries, and assets that provide carry (income) in a yield-starved world. Within U.S. stocks, we continue to focus on companies that offer some combination of high profitability, a low debt-to-equity ratio, good pricing power and earnings consistency. Stocks with these characteristics have historically performed well in more volatile markets.

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Russ Koesterich, CFA, JD
Russ Koesterich, CFA, JD, Managing Director and portfolio manager, is a member of the Global Allocation team.   Mr. Koesterich's service with the firm dates back to 2005, ...

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