My family and I were seated outside a restaurant for Sunday brunch. As we enjoyed our meal, a small bird landed at the next table. He pecked away at a bagel for a few minutes, then fluttered away. An older gentleman returned to the table and reached for the bagel the bird had enjoyed. We warned him that our feathered friend ruined his food. He shrugged and took a bite anyway. Noticing our surprise, he smiled and said, "I am French. It is not an excuse, just an explanation."

The most commonly cited reason for the recent stock market correction is the fear that interest rates are set to move much higher. But contrary to the Frenchman's witty remark, the consensus viewpoint is "just an excuse, not an explanation."

Higher interest rates can hurt stock values in two ways. First, higher inflation-adjusted (or real) interest rates make bonds more competitive with stocks in terms of future potential returns. This often will result in stock price declines to boost the future potential return of stocks and keep them competitive in the eyes of investors vs. less risky alternatives. Second, fear of accelerating inflation will raise the inflation risk premium demanded by fixed-income investors, especially in longer-term bonds. This increases the yield offered by bonds and makes them more competitive with stocks. In addition, significantly higher expected rates of inflation (think several percentage points higher) can impair economic activity and harm corporate profits. Lower profits harm stock values unless investors are willing to pay more for every dollar of earnings.

So how have higher interest rates hurt stocks in recent weeks? To judge the impact of real interest rates, we look to the market for Treasury inflation-protected securities (TIPS). The longest-dated TIPS, which compete most directly with stocks for long-horizon savings, currently offer an annual inflation-adjusted return of 1%. This offered return level is virtually unchanged from a month ago and has fluctuated by only a few tenths of a percentage point since early 2016. So changes in real long-term interest rates don't explain any of the stock market correction.

OK, so we can forget about higher real rates for now, but what about inflation?! Stock investors are suddenly worried that inflation is set to accelerate and that the Federal Reserve will have to react by raising short-term rates to a point that the yield curve becomes inverted and banks are forced to curtail lending, potentially causing a recession.

Again, we look to market data for evidence. The swap market for consumer price index (CPI) inflation does indeed show an uptick in the expected level of inflation over the longer term, but not to a degree that would impair economic activity. Fixed swap rates for 1-year zero coupon notes 5 years forward are roughly 2.3%, up from 2.2% at the beginning of the year. And fixed swap rates for 25-year zero coupon notes 5 years forward are 2.4%, up from 2.3% at the beginning of the year. Importantly, the spread in the swap rates between longer and shorter zero-coupon notes is little changed. This means that the inflation premium embedded in longer-dated bonds to compensate for the risk of accelerating inflation does not appear to have increased. If anything, the data suggests that the inflation premium has shrunk slightly since this past fall.

The message from Dr. Bond Market appears to be, "we expect long-run inflation rates to be slightly higher than we did a few weeks ago, but inflation expectations remain well anchored and we have little fear of significantly higher inflation." This suggests that the changes in interest rates experienced in recent weeks and months, which have predominantly occurred at the shorter-end of the maturity spectrum, should have little to no impact on stock values.

So why has Mr. Stock Market reacted so strongly to government statistics suggesting that (some) price levels have risen faster than expected? The simplest explanation is that stock price gains in 2017 and the first month of 2018 were at a pace that was out of step with the growth of corporate earnings. This left stock markets vulnerable to a correction if an excuse could be found for momentum traders to successfully push prices lower. Momentum traders found their excuse, and the correction ensued. But the global economic backdrop is as strong today as it has been in 20 years (with the notable exception of government balance sheets). Barring a shock (e.g., large-scale war, a global pandemic, severe political instability in a large economic area), we believe the current stock market correction likely will prove short-lived.