Understanding capital markets

Equity market investors continue to benefit from a strong 2024 market environment, this time with positive results spread among a wider swath of equities compared to 2023’s narrow leadership. Fixed income markets have struggled more in an environment where already-high interest rates have generally trended even higher.

“The macroeconomic backdrop for 2024 is one of continued growth, driven primarily by solid consumer spending,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “At the same time, inflation, while considerably lower than at its peak, is proving to be sticky, and staying above 3%.”

Performance in 2024 has been a mixed bag for stock and bond investors. The U.S. stock market, as measured by the S&P 500, gained just under 12% year-to-date through May 20, 2024. This comes on the heels of a more than 26% gain in 2023. However, 2024’s equity market is distinguished from 2023’s in that more sectors of the market are participating in the rally. While 2023’s gains were primarily generated by a narrow group of technology-oriented stocks, utilities, energy, financial and industrial stocks – along with technology – are among the participants in 2024’s rally.¹

By contrast, the bond market suffered a setback as interest rates generally moved higher, particularly on longer-term fixed income instruments. The yield on the benchmark 10-year U.S. Treasury, which ended 2023 at 3.88%, jumped to as high as 4.70% by late April 2024, though it retreated to under 4.5% by mid-May. As interest rates rise, bonds already on the market lose value. Year-to-date through May 18, 2024, the Bloomberg Aggregate Bond Index declined 1.51% on a total return basis.²

Haworth says the combination of reasonable economic growth but higher-than average inflation favors equities and real assets (such as commodities and real estate), with a reduced emphasis on fixed income positions.

Current capital market drivers

The economy proved resilient throughout 2022 and 2023 in an environment where the Federal Reserve (Fed) dramatically hiked interest rates in an effort to temper inflation. Inflation is still on the radar, as the Fed continues to pursue a long-term inflation rate of 2%.

In today’s environment, Haworth says investors should pay particular attention to three primary factors:

• The timing of potential Fed interest rate cuts. The Fed has indicated that rate cuts are likely to occur in 2024, but given inflation’s stickiness, the start of rate cuts has been delayed. This is keeping interest rates higher across the broader market, which is more costly to consumers and businesses looking to borrow. Markets initially surged on expectations of numerous 2024 rate cuts, but the U.S. stock market retreated in April 2024 as inflation remained high and investors feared Fed rate cuts would be further delayed. The stock market recovered lost ground in May 2024.
• The state of the economy. The economy continued to grow despite headwinds created by Fed monetary policy, driven primarily by healthy consumer spending. “How strong and resilient will consumers continue to be in 2024 and beyond? That’s an open question,” says Haworth, but the answer is likely to be key to whether the economy continues expanding.

• The direction of corporate earnings. Earnings, or a company's profits, are typically one of the biggest drivers of capital market performance. “S&P 500 earnings have grown for three straight quarters,” says Haworth, “in contrast to an earnings contraction that was underway in the first half of 2023.” Haworth says the earnings outlook for the rest of 2024 remains positive, which could provide support to the markets, as earnings growth helps lay the groundwork for rising stock prices. He also notes that stocks valuations are relatively high today, reflecting market expectations that earnings will continue to grow. If such growth fails to materialize, equity investors could face a more challenging environment.

While these factors are likely to have the greatest impact on equity and fixed income markets, investors need to be aware that other events can temporarily impact the markets and potentially contribute to investor uncertainty. Read more about our capital market perspective in our quarterly investment outlook.

Capital markets explained

Here are answers to some fundamental questions that may help you better understand capital markets and how they work.

What are capital markets?

Capital markets are a way to bring together individuals or institutions with money (also known as capital) they wish to invest, and various entities that seek money to underwrite costs to meet specific purposes. Capital markets also facilitate the issuance of securities on an exchange, where stocks and bonds are offered by those seeking capital, to be purchased by investors seeking to put capital to work.

For example, government entities regularly issue debt securities (bonds) to meet costs for major capital projects or, in the case of the federal government, finance day-to-day expenditures. Investors, in effect, lend money to the government entity by purchasing a bond. The borrower is required to pay interest on a timely basis and repay principal when the bond matures.

What are types of capital markets?

Capital markets are most commonly made up of stock and bond markets.

• Stock (equities) is issued by a corporation, providing an ownership stake in the firm. Individuals and institutions can purchase stock in the firm, obtain voting rights as a shareholder, and be a recipient of dividends paid out by the corporation from its earnings (profits). Stock values can rise and fall, and investors can re-sell shares through an exchange on the secondary market, which is where bonds or shares of stock are bought and sold after their initial public offering.
• A variety of entities issue bonds, such as governments, school districts and corporations. By purchasing a bond, the investor becomes a lender and is due interest and principal payments. Bondholders always take priority over stockholders when it comes to repayment, should the entity that issued the security face financial difficulty, such as bankruptcy.

How do capital markets work?

A key to capital markets is the issuance of securities. Entities seeking to raise capital will issue debt or equity securities that are exchanged with investors. A corporation, for example, may issue new shares of stock, at a set price. However, once on the open market, the price of a security is generally always changing, reflecting demand in the market.

When raising capital, companies or entities may issue new shares of a stock or bonds, with proceeds from investors going directly to the issuer to meet its current financial purposes. Original issues of stocks and bonds are not always accessible to individual investors, such as in an initial public offering (IPO) of stock. Most individuals purchase stocks on the secondary market, where those who previously purchased stocks or bonds can re-sell the securities they hold.

How do capital markets differ from financial markets?

There are similarities between the two; however, capital markets typically refer to the issuance of new securities to raise capital, while financial markets can refer to all forms of securities trading.

Financial markets encompass a wide variety of exchanges involving traditional securities like stocks and bonds, as well as other types of assets and contracts. Most individuals trade securities on the secondary market.

Talk to your financial professional

As you assess your own financial goals, understanding the current and anticipated performance of capital markets may help you more effectively position your assets to achieve your objectives. Discuss your circumstances with your financial professional to help determine the best steps to consider in today’s capital markets.

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