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While 2018 hasn’t been particularly smooth sailing for the U.S. equity market, it more or less continues its nine years long non-stop party.

While explanations for this year’s market volatility are complex, some of it can be reasonably attributed to investors’ reaction to interest rate movements and trepidation about the unknown end date of the current business cycle. These jitters are driven in part by the conventional wisdom that rising U.S. nominal interest rates are bad for equities. The Federal Reserve continues to raise rates, stoking unease among those who subscribe to the conventional wisdom.

Breaking down these concerns into their component parts yields two critical questions for equity investors: 1) when will higher rates become a headwind for equities? and 2) where are we in the business cycle? A recently published Equity Strategy report from Barclays Research addresses both concerns.

When will higher rates become a headwind for equities?

Conventional wisdom among investors is that an increase in rates is detrimental to equities. However, we found that market behaviour has not been historically consistent with this expectation, meaning this truism needs reevaluation. In examining the correlation between rates and equity performance historically, a 5% interest rate on 10-year Treasuries appears to be the critical turning point. But this may not hold true in the current business cycle, where rates might actually be detrimental for equities at a lower point. Watch to learn why.

Where are we in the business cycle?

Despite nine years of economic expansion, the evidence indicates we are just now entering the late stage of the current business cycle. Firstly, while leading economic indicators such as the yield curve and the Leading Economic Index are turning amber, they are not flashing red yet. For instance, the spread between the 10-year and 3-month Treasury yields usually turns negative prior to recessions. While spreads have flattened since the start of the year, they have not entered negative territory yet.

A negative 10 year-3 month yield spread indicates a high likelihood of a near-term recession
Graph depicting 10 year - 3 month yield spreads from 1962 to 2018

Source: Barclays Research, Bloomberg.
Note: Blue shaded areas show National Bureau of Economic Research recessions.

Secondly, companies are exhibiting capital discipline. Although corporate debt is at historical highs relative to sales, it can be easily serviced thanks to relatively low rates and plenty of cash on hand given high margins.

While SPX debt levels have been climbing, the ability to service that debt remains strong
Graph depicting debt divided by sales versus interest rate coverage ratio from 1989 to 2018

Source: Barclays Research, Thomson Reuters. All Ratios are using LTM data.
Interest Coverage Ratio is defined as LTM EBITDA divided by LTM Interest Paid.

Additionally, companies have not ramped up capital expenditures despite all the cash at their disposal. Instead they are returning cash to shareholders via share buybacks, which can be discontinued at will as the business cycle winds down.

Capex levels are below historical highs and have trended down since 2014...
Graph depicting fixed investment divided by GDP versus S&P 500 index ex-Financial Services capital expenditures divided by sales from 1989 to 2018

Source: Barclays Research, Thomson Reuters, Haver Analytics

...while capital being returned to investors is near all-time highs
Graph depicting dividends and net buybacks among S&P 500 index participants from 1994 to 2018

Source: Barclays Research, Thomson Reuters, Haver Analytics

The party continues

While the market remains somewhat volatile, the conclusion of the business cycle does not appear to be imminent. Looking at the rate equity correlation with fresh eyes, we believe the inflection point of a 3.7% rate in 10-year Treasuries won’t be reached for some time, even if the Fed continues to hike rates at its current pace. Therefore, we remain cautiously optimistic on U.S. equities.

Read the full report

Authorised clients of Barclays Investment Bank can dive deeper into this issue by logging in to Barclays Live to view the full report, entitled U.S. Equity Strategy: It’s late, but the party’s still going (11 June 2018).

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About the analyst

Maneesh S. Deshpande is a Managing Director and Head of US Equity Strategy and Global Equity Derivatives Strategy at Barclays. For the past 10 years Barclays Equity Strategy team has been consistently ranked in the Equity Derivatives/Equity Linked category of the Institutional Investor's annual survey. Mr. Deshpande joined Barclays in September 2008 from Lehman Brothers, where he worked in a similar role.

Prior to that he established and ran the Systematic Portfolio Trading desk at Goldman Sachs, was the Head of Principal Trading at Morgan Stanley Japan, and the Head of US Interest Rate Options Trading at BNP Paribas. Mr. Deshpande earned a PhD in Theoretical Physics from the University of Pennsylvania and BS in Electrical and Electronics Engineering from the Indian Institute of Technology, Madras.

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