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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Do higher interest rates lead to lower investments?
Peter Garnry
Chief Investment Strategist
Summary: The conventional wisdom goes that higher interest rates cool the economy and investments are negatively impacted, but data on S&P 500 since 2003 suggest the opposite. When the US 10-year yield is in its fourth quartile this is actually when the subsequent one year growth rate in S&P 500 investments across research and development, and capital expenditures is the highest. Given all the talk about recession it is also worth noting that the growth in total investments among S&P 500 companies is now the highest in 11 years.
High growth in investments among S&P 500 companies
Accounting rules generally do not allow a lot of intangible investments to be capitalized on the balance sheet and thus we often only discuss capital expenditures when analysts are writing about investments among companies. But investments in brands (marketing expenses) or products (research and development expenses) are often expensed over the income statement and thus left out. While marketing expenses are rarely separated in foot notes the R&D expenses are and thus we can at least calculate the total investments in the S&P 500 by adding capital expenditures and R&D expenses.
The current level of total investments in the S&P 500 is $174 per share which is around 10% of revenue and 4.4% of the current market value and up 19.2% from a year ago. The current growth in total investments in the S&P 500 Index is the highest since late 2011 as the global economy was accelerating out of the Great Financial Crisis. Before that this level of growth was seen around the period 2005-06 as the global credit boom was lifting corporate sentiment and investments. While many CEOs talk about uncertainty, higher interest rates, and changing globalisation they are still confident enough to make big investments for the future. This underpins the argument that the economy will not even do a soft landing but accelerate and likely overheat adding to inflationary Will high interest rates kill growth?
We have been through period, and maybe we are still in it, where our lack of causal understanding of what drives inflation have been illuminated. If we understand inflation dynamics properly then we would most likely not have ended up in the current situation, but that is of course pure speculation. The other day one economist was mentioning that the higher interest rates were increasing costs for businesses as their floating loans were constantly refinanced at higher interest rates and that investments would likely decline. It sounds plausible that when capital gets more expensive that investments would be negatively impacted. But what if the causality is the other way around? What if low interest rates actually signals that few interesting investments are available in the economy.
If we split the US 10-year yield into quartiles then we can measure the growth in investments in the S&P 500 over the subsequent 12 months. The fourth quartile starts at the 3.84% level in the US 10-year yield and the average annual growth rate in total real investments (here we subtract inflation) in the subsequent year is 9.2%. This level is considerably higher that the third and second quartiles of 2.6% and 2.8% average annual growth rates. The first quartile splits at the 1.99% yield and in the low interest rate environment we measure subsequent growth of 5.9% on average. While these data points are not conclusive, and a proper study should broaden out the data analysis over a longer period and across more countries. But it is an interesting observation that since 2003 the highest growth in S&P 500 real investments has been during periods with the highest level of bond yields. So maybe the evidence is not that supportive that higher interest rates will kill the investment rate in the economy.
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