Interest rates – through the discount rate for future cash flows – are fundamental to stock investing

This comprehensive article by Nuclo Independent CIO’s head of global equties Claudio Brocado was originally published on the Nuclo website on June 19, 2020, but it clearly explains what is going on right now across global markets. At the time the report was written, there was widespread talk of stocks not reflecting the economic “fundamentals.” The equity markets had ‘decoupled’ from the real economy, which was much weaker, the argument went. Claudio argued forcefully that the prevailing (and expected) level of interest rates was indeed fundamental to the valuation of stocks.

This, obviously, applies both when long-duration equities are rising, as when they are falling. The market turbulence of the last few weeks (particularly when it comes to growth stocks) is very much being caused by investor worries that interest rates have risen too quicky. We believe that market participants (as they often do) are extrapolating the yield-curve steepening of the last few weeks well into the future. We believe recent moves in global interest rates (led again by the US) are a sign of the globally-synchronized economic boom we are to experience. Following a brief inflation surge, we expect price increases to stabilize closer to key central bank targets, not above. As always, time will tell. From the full report here:

“The fixed income (bond) markets have traditionally been considered the key determinant of long-term interest rates in free-market economies. It is also widely believed that fixed income markets tend to lead their equity counterparts. Thus, one of the most-widely followed leading indicators of economic recessions is the inversion in the yield curve, whereby longer-term interest rates drop below short-term yields.

Obviously, interest rates are intimately linked to economic activity, and changes in rates interact with the economic outlook in a variety of ways. There are important feedback loops, in which meaningful changes in interest rates (a dramatic and quick inversion in the yield curve, for instance) presage inflection points in economic growth prospects. Thus, a major inversion in the yield curve is often associated with a subsequent significant drop in GDP for the country affected.

Iterative effects may well then kick in, as a rapidly slowing economy is likely to produce drops in bond yields. Eventually, the monetary authorities (often led by the Fed) cut interest rates enough to bring about a subsequent economic recovery. As the Fed has traditionally had more leverage on short-term yields, significant cuts to shorter-term interest rates eventually drive them under their long-term counterparts, ‘normalizing’ the yield curve, and being seen by financial markets as signs of better economic times to come…”