In part 1, we get a sense of what we might expect in a cycle of rising long-term interest rates by looking at a bunch of historical data. Now we continue to investigate the relationship between interest rates and intrinsic value.
Interest Rates and Intrinsic Value
All else being equal, there's no getting around the fact that higher interest rates reduce the value of financial assets. Imagine for a moment a stock that pays annual dividends of $1 a share with zero growth potential, and in order to own this stock, investors demand a 6% premium to the return on long-term Treasury bonds. If the 10-year Treasury yields 2%, investors require this stock to return 8%, so it's worth $12.50 a share ($1 divided by 0.08). If the 10-year yield rises to 4%, the required return jumps to 10%, making the stock worth $10--a decline of 20%.
However, all else is almost never equal. Let's recast the example as a stock with a $0.50 dividend rate and a 4% growth rate for earnings and dividends. Given a 10-year Treasury yield of 2% and a 6% equity risk premium, this stock is worth $12.50 a share ($0.50 divided by 0.04, which in turn reflects the 8% investor return requirement minus the 4% growth rate). If the 10-year Treasury yield jumps 2 percentage points, but the company's growth rate increases by 2 percentage points as well, the two increases cancel each other out to leave the stock's intrinsic value unchanged.
This explains why utilities are generally the worst performers relative to the market when long-term interest rates rise. Periods of low interest rates are usually associated with a weak economy--during or just after a recession. Utilities (at least fully regulated ones) tend not to suffer much by way of profit declines because the services they provide are nondiscretionary. When economic growth starts to improve, corporate profits rebound and interest rates trend higher--but regulated utilities are less likely to enjoy faster profit growth than other more cyclical sectors of the market. Similarly sticky dynamics are at work in consumer staples, telecoms, and real estate investment trusts.
However, these sectors generally have the least to lose when the economy falls into its next recession. I'm happy to swap short-term underperformance during bull markets for better downside protection.
The Key Question: What's Priced In?
One of the more curious features of our current rate cycle is the reason interest rates have gone up. Usually, rates rise because of a combination of faster economic growth and upward pressure on inflation. But on the way to a full-percentage-point increase in the 10-year Treasury yield, the economy hasn't actually gotten much stronger, and inflation remains below the Federal Reserve's target rate of 2%. Instead, rates are up because the bond market fears an end to the Federal Reserve's most aggressive stimulus measures whether the outlook for inflation changes or not.
I don't have any specific outlook for interest rates, but I think it's safe to say that interest rates will eventually rise further. A 10-year Treasury yield of 4% seems like a reasonable planning assumption if the economy picks up a bit more speed and inflation stays low. But how and why we get there is more important than when. If interest rates rise because of a jump in inflation, that probably won't be good for stocks of any kind--but that's why I require dividend growth to maintain the purchasing power of our income. If rates rise because the economy is growing faster, that too should correlate with faster dividend growth from our stocks, even if more cyclical areas benefit more than we do. And if rates rise too fast or too far, the key threat might be a recession, in which case our defensive stance is ideal.
Under any scenario, strong corporate balance sheets and economic moats are our best defenses. Moats are particularly valuable: By fending off the impact of competition, they help protect the profits that fund our dividends through downturns while encouraging dividend growth in better times. I wouldn't go through any interest rate or economic cycle without them.
The best news for income-oriented investors is that relatively few stocks--unlike virtually all bonds--were priced for 10-year Treasury yields staying at 2% forever. Morningstar's fair value estimates have never been predicated on the idea of a 2% 10-year Treasury yield. Instead, the equity return requirements embedded in the valuations of our portfolio holdings are either 8% (for the most stable businesses) or 10% (more-or-less average predictability). If rates continue to rise, I won't be surprised if these generally defensive stocks lag the market, but that's not my conception of risk. Due to our resilience in weaker periods, our portfolios have performed much better the S&P 500 over time without making any explicit attempts to forecast economic indicators or shifts in market sentiment.
In the final analysis, the beauty of high-quality, high-yielding stocks is that they offer "unfixed" income--attractive dividend growth potential--which long-term Treasuries do not. As long as our dividends are safe and continue to grow, I expect rewarding long-run results from our strategy, even if interest rates have further to rise.
