Interest Rates and Equity Valuations

A large body of work has sought to measure the effect of interest rates on equity valuations. The challenge in doing so is that both are endogenous, and their comovement depends on the forces driving interest-rate changes. To address this problem, we develop and estimate a decomposition that splits movements in real rates into three structural drivers: changes in expected growth, risk, or “pure discounting.” We show that only pure discount-rate shocks transmit one-for-one to equity valuations, with little or negative transmission of growth and risk shocks. Implementing our decomposition with a global panel of growth expectations and asset prices, we find a weak unconditional relation between valuations and real rates but a strong relation with the pure discounting component, which explains 80% of cross-country valuation changes since 1990. In the U.S., we find that 35% of the interest-rate decline is attributable to pure discounting, implying that only a fraction of the change in rates has passed through directly to equities. We use the decomposition to revisit evidence on the role of interest rates in explaining price variation, and to study higher-frequency returns, cross-sectional rate exposures, duration-matched equity premia, and reactions to monetary policy.