How do rising interest rates affect the stock market?
- A changing interest rate environment contributed to headwinds for the stock market.
- The Federal Reserve’s major policy shift removed liquidity from the markets and led to a repricing of risk assets such as stocks.
- With rates remaining elevated, stocks may continue to face a volatile environment in the coming months.
The investment landscape experienced a notable shift in the first half of 2022, highlighted by a significant rise in interest rates and a persistent surge in the inflation rate. While this had a clear impact on fixed-income investments (the value of bonds declines when interest rates rise), stocks were not immune to the effects of the changing environment. By June 2022, significant “repricing” occurred in the stock market, and the Standard & Poor’s 500 stock index, a key indicator for U.S. equities, slipped into a bear market, representing a decline of 20% from its peak value.
The Federal Reserve (Fed) sought to ease the inflation threat by initiating a dramatic policy change early in the year. The Fed’s moves are designed to slow the rate of economic growth, ideally without pushing the economy into a recession. The revised Fed policy appeared to have a major impact on the broader interest rate environment. Bond yields followed an upward trend through much of the first half of the year.
Rising interest rates altered the landscape for equity investors who became accustomed to an environment where interest rates remained low for an extended period of time. What does this mean for the equity portion of your portfolio?
The Fed’s previous “easy money” stance
For a two-year period dating back to early 2020, and for much of the decade prior to that, the Fed pursued what is termed an “easy money” policy. This includes maintaining the fed funds rate at fairly low levels and expanding its balance sheet of bond market holdings. The Fed took significant easing steps as COVID-19 first emerged in February and March of 2020. It lowered the fed funds target rate to near 0% and boosted its holdings of Treasury and mortgage-backed debt securities.
“As the Fed tightens interest rates, we can expect a decline in economic growth.”
– Eric Freedman, chief investment officer, U.S. Bank Wealth and Institutional Asset Management
This helped keep interest rates low across the bond market. Risk assets took on greater appeal. This is due at least in part to the reality that investors couldn’t earn attractive returns in fixed income investments.
Investors farther out on the risk spectrum looked upon the Fed’s so-called “easy money” policy with favor. “Supportive monetary policy was critical for risk asset owners, whether it be in domestic equities, real estate or cryptocurrency,” says Eric Freedman, chief investment officer for U.S. Bank. In 2020 and 2021, the S&P 500 gained 18.40% and 28.71% respectively.
The U.S. economy also performed well over most of this period. After a significant decline in the first half of 2020 (tied to the outbreak of COVID-19), the economy proved resilient. In 2021, the economy grew by 5.7% as measured by Gross Domestic Product (GDP), it’s strongest calendar year of growth since 1984.1 That helped the Fed make progress in meeting one of its mandates, achieving “maximum employment” in the economy. While the Fed states that this goal “is not directly measurable and changes over time,” employment trends remain positive today.2 For the better part of the past four decades, inflation and interest rates were relatively low. It’s an environment that tends to favor equity investors. The question going forward is the degree to which circumstances may change.
A sudden surge in the inflation rate prompted the Fed’s decision to alter its monetary stance. In 2021, the cost-of-living as measured by the Consumer Price Index rose 7%. Inflation over the 12-month period ended June, 2022 reached 9.1%, the highest increase in annual living costs since 1981.3 This far exceeds the Fed’s goal of maintaining annual inflation in the range of 2% over the long term.
Changes in the bond market reflect the Fed’s policy shift. The yield on the 10-year U.S. Treasury note, a benchmark of the broader bond market, rose from 1.52% at the end of 2021 to a high of 3.49% in June 2022. Yields on the 3-month U.S. Treasury bill (more closely related to the fed funds rate) jumped from 0.06% at the end of 2021 to 2.5% by mid-July 2022.
Higher rates alter the equity investment landscape
There are various reasons why increasing interest rates can have an impact on equity markets. One is that it could affect future earnings growth for U.S. companies. “As the Fed tightens interest rates, we can expect a decline in economic growth,” says Freedman. In fact, GDP growth slowed in the first half of 2022, even declining by an annualized rate of 1.6% in the first quarter of the year.
“The Fed has telegraphed its intention to raise interest rates further,” says Freedman. In this environment, stocks have temporarily lost some of the appeal they had during the Fed’s “easy money” period prior to 2022.
One reason for the change is that as bonds, certificates of deposit and other vehicles pay more attractive yields, it could create greater competition for stocks. “If interest rates move higher, stock investors become more reluctant to bid up stock prices because the value of future earnings will look less attractive versus bonds that pay more competitive yields today,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. Present value calculations of future earnings for stocks are tied to assumptions about interest rates or inflation. If higher rates are anticipated in the future, the present value of future earnings for stocks are reduced. If this occurs, it may put more pressure on stock prices.
“The hardest hit stocks have primarily been those with premium price-to-earnings (P/E) multiples,” says Haworth. In other words, stocks that are considered “pricey” from a valuation perspective suffered the largest price declines. This included secular growth and technology companies that enjoyed extremely strong performance since the pandemic began. Haworth notes that prior to the Fed’s policy shift, a number of stocks that generated little to no current earnings saw their stock prices inflated as investors focused on the potential for future earnings. “Markets aren’t as likely to ‘pay up’ for stocks that are unable to generate meaningful earnings if interest rates continue to move higher,” says Haworth.
A less predictable environment
One of the biggest questions is the degree to which the Fed will have to tighten its monetary policy to slow inflation. When the inflation rate first jumped above the 5% level in May 2021, Fed officials indicated they thought it was a temporary move that would correct itself. However, elevated inflation rates proved to be more persistent, and the Fed felt its hand was forced.
“It’s clear that the Fed policy shift created great change in the markets,” says Bill Merz, senior vice president and senior portfolio strategist at U.S. Bank Wealth Management. “2022 is very different from 2021. The potential for volatility in capital markets remains high and the range of possible outcomes is wide.” Merz notes that the Fed faces a difficult balancing act, trying to temper growth sufficiently to tamp down the inflation threat without causing a recession.
It should be noted that a changing interest rate environment, while creating more headwinds for stocks, doesn’t mean there isn’t continued upside opportunity. “The key is how well companies will perform over the remainder of 2022 and in early 2023,” says Haworth. “A major question is whether earnings expectations are downgraded. That hasn’t occurred through the middle of 2022, but if it did, that might result in further pressure on stocks.” One key earnings variable is whether companies can sufficiently raise prices for their goods and services to keep pace with rising costs reflected in the elevated inflation rate. Another is whether the economy avoids a recession. A struggling economy would likely detract from corporate earnings and create more risks for the equity market.
There are reasons to be prepared for the prospect of additional asset repricing similar to what propelled stocks into bear market territory in the first half of the year. A key variable likely to weigh on the markets will be how aggressively the Fed raises interest rates.
Putting your portfolio into perspective
As you assess your own circumstances, it may be wise to maintain lower expectations for equity market performance in the near term. Nevertheless, assuming the Fed succeeds in tempering inflation and the economy recovers, stocks remain well positioned over the long term. At the same time, it’s important to be prepared for the potential of ongoing market volatility.
Talk to your wealth professional about your current comfort level with your portfolio’s mix of investments and discuss whether any changes are appropriate in response to an evolving capital market environment.