What, Stock Fund Investors Worry About Rising Rates?

A lot of investors are worried about rising interest rates and inflation, and not without cause. The yield on the 10-year Treasury bond is at a generational low; government spending and borrowing has erupted; and, although the Fed has said it'll keep its funds rate near zero for "an extended period," that won't last forever. When rates do increase, bond owners will feel it. On that much, most investors agree. There's less consensus on equities. Stocks may be better off than fixed income when interest rates rise, but it's not clear by how much.

No Slam-Dunk
To stay competitive if bond yields rise far enough, the market may reset stock valuations lower to increase their prospective long-term returns. Rising interest expenses also could clip corporate profits. Both of those possibilities spell poor returns for stocks at least in the short term.

How rates rise matters, too, though. High valuations at the start of a rate-tightening cycle can make stocks more sensitive to hikes. Sharp, unexpected spikes in inflation and interest rates, which often coincide, increase the odds of lousy equity returns, but there's still a wide range of possibilities, says Fran Kinniry, an investment strategist with Vanguard. Stocks on average have lost 2.3% when inflation and interest rates rose unexpectedly, according to a Vanguard study. But the range of results is wide, including a period with a 53% gain, Kinniry says. So it's not a slam-dunk that stocks are going to do poorly.

Gradual rate increases might be easier to take and even be welcome--especially if they come because of economic growth. Indeed, some businesses are counting on higher rates to help them.  Charles Schwab (SCHW), for example, gave up $125 million in 2010's first quarter alone on money market fee waivers. Higher rates could allow the firm to make money again on its money market assets, or at least stop the bleeding.

Unpredictable but Tolerable
Higher rates will affect stocks in unpredictable ways, but long-term stock fund returns haven't always suffered when interest rates climb. When the yield on the 10-year Treasury went from less than 4% to the low-to-mid-teens in the 20 years after 1963, the average domestic-equity fund in existence at the time gained nearly 490% cumulatively. That beat the S&P 500 Index, which gained 411% cumulatively, and inflation, which averaged more than 220% cumulatively, over the period. The top-performing funds over that span were  Van Kampen Enterprise  and  T. Rowe Price New Horizons (PRNHX), with cumulative gains of nearly 1,300% and 1,200%, respectively. Seligman Growth  was the worst, with a 73% cumulative gain.

Granted, past is not prologue, and few of those funds resemble their old selves. Some have changed their strategies, and no manager who was running one of these funds on Jan. 1, 1963, is still on the job today. There are some managers, however, who started in the midst of that era, such as  American Funds American Mutual's (AMRMX) James Dunton,  Royce Pennsylvania Mutual Investment's (PENNX) Chuck Royce,  Franklin Growth's (FKGRX) Jerry Palmieri, and  CGM Mutual's  Ken Heebner. So, if you are looking for veteran investors who remember how to work in an environment of high inflation and interest rates, they're out there. In the end, staying the course with proven funds could be the best way for equity investors to cope with the prospect of rising rates.

A version of this story originally ran as a feature in Talking Points, a series of analyses highlighting themes and insights stemming from Morningstar's conversations with fund managers. Talking Points is available to subscribers of Morningstar's Principia and Workstation software.