Goldman Sachs has formulated the perfect scenario for stocks to fight back against higher interest rates

Reuters / John Gress

• The Federal Reserve is gradually raising interest rates, and investors are wondering how much of a blow that will be to the appeal of stocks relative to other asset classes.
• Goldman Sachs has formulated an exact - not to mention entirely plausible - scenario that could keep the equity market rising.

Conventional market wisdom suggests that when interest rates rise, stocks are likely to fall as the relative appeal of bonds increases.

Not so fast, says Goldman Sachs, which makes a compelling argument that the equity market can withstand the pressure applied by higher rates by making up for it elsewhere.

The firm expects strong earnings growth to function as the market's ace in the hole, with its accretive effect on stock prices more than offsetting the negative impact of gradual rate hikes.

After all, the same dynamic played out during the past three tightening cycles from the Federal Reserve - in 1994, 1999, and, 2004 - periods also characterized by robust profit growth, according to Goldman.

And if there's any doubt around the ability of corporations to continue expanding profits to that degree, consider that S&P 500 firms are expecting to see earnings growth of 23% for full-year 2018, their best result since 2010.

But stocks need more help than just profit growth, which is where Goldman's forecasting prowess comes in. The firm has considered other variables, and constructed a completely reasonable scenario that it says could keep the stock market chugging higher, if conditions are met.

Goldman says the equity risk premium - or the excess return investing in stocks offers over a risk-free rate - will decline when rates rise, but can be contained enough to push equities higher if: (1) inflation remains centered around 2% and (2) 10-year Treasury yields stay below 3.5%.

One important caveat involves the pace of the Fed's rate hikes. Goldman notes that past instances of its bullish stock scenario have all been characterized by gradual increases. Fortunately for them - and for stock bulls - the Fed appears willing to comply.

The chart below provides a visual representation of what Goldman is describing. As indicated by the arrow, when rates are rising in gradual fashion, the S&P 500 can still generate above-average returns, relative to Treasurys.

"These conditions are constructive for equities and represent our baseline forecast for 2018," David Kostin, Goldman's head of US equity strategy, wrote in a client note. "However, as bond yields approach 4%, the growth-inflation mix embedded in interest rates could weigh on equities."

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