Impact of surging interest rates on equity markets: Analysis of rate hikes and stock market fluctuations
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Throughout 2022, the market landscape underwent a significant shift, primarily due to a surging inflation rate and increasing interest rates. Unfortunately, this wasn't kind to stock markets. By June, the Standard & Poor's 500 stock index, an indicator of U.S. equities' performance, plunged into a bear market, signifying a 20% decline from its peak value.
To combat inflation, the Federal Reserve (the Fed) made a seismic policy change in early 2022. The Fed's objective here is to slow down economic growth, but they're not targeting a recession. However, their revisions seem to have had a considerable impact on the wider interest rate environment. For much of the year, bond yields demonstrated an upward trend.
The rise in interest rates has transformed the investment landscape, as investors had cultivated a taste for a prolonged low-interest environment for quite some time. But what's the connection between interest rates and the stock market? How does this affect your equity investments?
The Fed's Previous "Easy Money" Policy
The Fed's "easy money" policy adopted since 2020 (and lasting for a large part of the previous decade) included maintaining low fed funds rates and increasing bond market holdings. As COVID-19 emerged in February and March 2020, the Fed took drastic measures to ease, slashing the Fed funds target rate near 0%, and boosting its holdings in Treasury and mortgage-backed securities.
This resulted in low interest rates throughout the bond market. Risk assets attracted investors due to uncompetitive returns in traditional fixed-income investments. Those on the riskier investment spectrum embraced the Fed's "easy money" policy positively. Eric Freedman, U.S. Bank's Chief Investment Officer, shares, "Supportive monetary policy was essential for all investors, irrespective of whether their investments were domestic equities, real estate, or cryptocurrencies." Consequently, the S&P 500 grew 18.40% and 28.71% in 2020 and 2021, respectively.
For the most part, the U.S. economy thrived throughout this interval. It recovered impressively from a downturn in the first half of 2020 caused by the onset of COVID-19, even managing a 5.7% GDP growth in 2021. This supported the Fed's mandate to achieve "maximum employment," despite acknowledging the goal as not easily measurable and subject to change over time. Although employment trends remain favorable, inflation and interest rates have been low for the majority of the past 40 years, making for a conducive environment for equity investors. But the future might bring changes.
The Fed amended its monetary policy due to a sudden spike in inflation. The Consumer Price Index, which measures the cost of living, soared by 7% in 2021. In a 12-month period ending June 2022, the CPI indicated a 9.1% inflation increase, significantly surpassing the Fed's long-term target of maintaining inflation within the 2% range.
The Fed's policy transformation echoed changes in the bond market. In June 2022, the U.S. 10-year Treasury note yield stood at 3.49%, jumping from 1.52% in 2021 and hitting a high of 3.49% in June 2022. Additionally, yields on the 3-month U.S. Treasury Bill, closely tied to the fed funds rates, escalated from 0.06% to 2.5%, from the end of 2021 to mid-July 2022.
The Impact of Higher Rates on Equity Investment
Interest rates could affect equity markets for various reasons. Eric Freedman explains that increasing interest rates may lead to a decline in the growth of U.S. businesses through an increase in their future earnings. In fact, the U.S. economy shrank in the first half of 2022’s first half, with a Q1 GDP decline of an annual rate.
Freedman suggests that the Fed will likely raise interest rates further. As a result, stocks have become less alluring in the environment created by the Fed's "easy money" period before 2022. This is because bonds, certificates, and savings accounts offer higher yields, making them more competitive with stocks.
Rob Haworth, senior financial strategy director at U.S. Bank Wealth Management, notes that as the interest rates rise, stock investors are less likely to bid up stock prices. The future earnings for stocks lose their attractiveness due to the higher yields on offer in bonds. This future earnings' present value depends on inflation and interest rates. Anticipated higher rates in the future will reduce the stock's present value, potentially causing additional pressure on stock prices.
Haworth indicates that companies with high price-to-earnings ratios have suffered the most. Tech and secular growth firms, which have enjoyed strong performance since the pandemic, experienced some of the largest drops. Haworth points out that companies with slim current earnings saw their stock prices surge before the Fed altered its policy, as investors focused on future earnings. As rates keep rising, markets will be less likely to "pay up" for stocks with poor earnings.
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Source: https://www.usbank.com/investing/financial-perspectives/market-news/how-do-rising-interest-rates-affect-the-stock-market.html#:~:text=%E2%80%9CIf%20interest%20rates%20move%20higher,U.S.%20Bank%20Wealth%20Management.
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Understanding the Connection Between Rising Interest Rates and Stock Performance
Rising interest rates have the potential to significantly influence stock performance and investments through several factors:
- Cost of Capital: With higher interest rates, the cost of borrowing for businesses rises, potentially discouraging capital expenditures and adversely affecting the financial stability of companies, consequently impacting their stock prices.
- Consumption: Increased interest rates may make borrowing more expensive for consumers, reducing their spending power. This can lead to lower revenues for businesses, particularly those reliant on discretionary spending, such as retail and consumer goods.
- Market Sentiment and Volatility: Rising interest rates often accompanied by uncertainty in financial markets lead to increased volatility and negatively affect investor sentiment. Investors may shift portfolios away from equities, favoring fixed-income securities with more appealing yields.
- Portfolio Reallocation: As interest rates increase, bonds and fixed deposits may become more attractive compared to equities, resulting in capital withdrawals from the stock market, pressuring stock prices.
Impact on Investment Portfolios
Rising interest rates can affect various aspects of investment portfolios, including:
- Sector Performance: Select sectors, such as real estate and finance, could be affected differently by the changing interest rates. For instance, higher interest rates may hurt Real Estate Investment Trusts (REITs), but initially bolster bank stocks due to increased ROI.
- Risk Management: Investors may need to reassess their portfolios to account for the risks associated with higher interest rates, focusing on stocks with stable earnings or companies with limited reliance on debt for operations.
- Reallocation: Investors may choose to rebalance their portfolios by reducing equity exposure and increasing investment in fixed-income securities to take advantage of higher yields.
Summary
In summary, rising interest rates tend to increase borrowing costs, reduce consumer spending, boost market volatility, and attract investors towards fixed-income offerings with higher yields. These factors can negatively impact stock performance and necessitate strategic adjustments to investment portfolios.
- In light of the Fed's decision to raise interest rates, investors may need to reassess their equity investments due to the increased competitiveness of bonds and savings accounts.
- As interest rates continue to rise, stocks with high price-to-earnings ratios are likely to suffer the most, particularly tech and secular growth firms, which have enjoyed strong performance since the pandemic.
