Key takeaways
Solid economic growth and strong corporate earnings continue to bolster stock prices despite higher interest rates.
The Fed’s indication that interest rate could be lowered in 2024 appear to be helping fuel positive investor sentiment.
Interest rates are much higher today than was the case in March 2022, when the Federal Reserve (Fed) first began raising the short-term federal funds target rate it controls. During the early months of Fed rate hikes, the S&P 500 suffered a 25% decline. By late 2022, stocks began to recover, and generated a solid 2023 return, with the S&P 500 up more than 26%. In 2024’s first quarter, stocks continued the momentum, gaining more than 10%.1
Investors appeared to respond positively to a surprisingly strong U.S. economy and favorable corporate earnings trends. However, investors are still influenced by Fed interest rate policy. Expectations that Fed rate hikes are completed and interest rate cuts may lie ahead could be a contributing factor in the current “bullish” stock environment.
S&P 500 performance in the opening weeks of 2024 is dominated by the same narrow band of tech-oriented stocks that outperformed the broader market in 2023.1 This segment of the market represents companies that may not be highly dependent on issuing debt and incurring higher interest costs.
How are interest rates likely to impact the stock market over the course of 2024?
In response to an inflationary surge that began 2021, the Fed bumped interest rates higher eleven times, from near zero percent to a range of 5.25% to 5.50%. The last rate hike occurred in July 2023. The Fed’s strategy was to slow economic growth and employment to temper the inflation threat. In February 2024, inflation over the previous 12 months stood at 3.2%, much lower than its mid-2022 peak of 9.1%, but not yet down to the Fed’s 2% target.2
“The Fed is very focused on achieving its long-term inflation target of 2%,” says Eric Freedman, chief investment officer at U.S. Bank Wealth Management.
Investors today may view the Fed as being a positive factor for the markets, according to Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “We now appear to be at a point where further interest rate hikes are off the table, so investors feel they can take some cover from that, as they anticipate the Fed’s next move will be to reduce interest rates.” Haworth says the bigger question at this point is the timing of such rate cuts.
Today’s higher interest rate environment can mean different things to different kinds of companies. “When interest rates first moved higher in 2022, it took its largest toll on stocks with already high valuations,” says Haworth. That included growth-oriented technology stocks that prospered in a low interest rate environment. “In 2023, as interest rates appeared to be approaching peak levels for this cycle, the impact shifted,” says Haworth. “The focus now is on how interest rates impact company finances, and that negatively impacts a different segment of the stock market, namely smaller stocks.” Smaller companies tend to be more dependent on debt issuance. “For many smaller companies, the cost of funding at higher interest rates are a bigger concern than is the case for many larger companies, which have more cash on hand and often issue longer-term debt,” says Haworth. Markets appeared to recognize this fact. As a result, after underperforming small-cap stocks in 2022, large-cap growth stocks far outpaced small stocks in 2023 and have started 2024 in the same, advantageous position. This chart compares performance of large-cap growth stocks (S&P 500 Growth) and small-cap stocks (Russell 2000 Index).
Haworth says a primary concern now is at what point the market’s strength, still concentrated on technology-oriented stocks, reaches a broader spectrum of the stock market. “Cyclical stocks that typically respond well to a stronger economy have yet to see the market rotate their way,” notes Haworth. “There’s still a lot of room for the market's strength to broaden out to more sectors.” For example, he points out that the utilities and real estate sectors are highly interest-rate sensitive, and are likely to benefit once rates begin to decline.
While interest rate trends can have a bearing on the stock market, performance is also closely tied to the strength of the U.S. economy. “As the Fed raises interest rates, we typically expect slower economic growth,” says Eric Freedman, chief investment officer, U.S. Bank Wealth Management. Surprisingly, however, Gross Domestic Product (GDP) grew more quickly in 2023 (2.5%) than it did in 2022 (1.9%).3 The economy’s continued growth in the face of higher interest rates was due in large part to strong consumer spending, fueled by above-average wage growth.
Haworth notes that modest corporate earnings growth occurred in 2023’s final two quarters. “If we assume interest rates are near a peak for the current cycle, economic trends and specific company considerations are likely to have a greater bearing on stock performance going forward.” Haworth says investors are likely to put more emphasis on factors such as how fast companies can grow and whether they are experiencing sufficient earnings growth.
Yet interest rates are still a consideration for equity investors. Stock prices tended to track with bond yield trends over the course of 2023. When interest rates rose, stock prices retreated, and when rates fell, stocks reacted favorably. Haworth still anticipates a continuation of the kind of market volatility that’s existed since mid-2023. “The market is waiting for more news in terms of the timing and extent of Fed rate cuts in 2024.”
The market remains heavily focused on the Fed's next decisions about interest rates. The Fed held the line on rates after its last rate hike in July 2023. After its March 2024 meeting, Fed chair Jerome Powell indicated that Fed rate cuts were likely in 2024,4 but the timing of such cuts remains a question mark. “The Fed is very focused on achieving its long-term inflation target of 2% (still below the current rate of 3.2%),” says Freedman.
While interest rates may fluctuate up-and-down in the near term, with some ramifications for stocks, it isn’t the only factor equity investors should consider. “One of the variables we’re watching is whether the declining inflation rate results in stock valuations appearing more reasonable,” says Haworth. He notes that if inflation declines from current levels, it would generally benefit stock valuations.
Nevertheless, stocks may still be subject to near-term volatility. “To bid stock prices higher, investors need to believe that earnings will grow faster than is indicated by current expectations and generate more attractive growth potential than the current elevated yields on fixed income instruments,” says Haworth.
As you assess your own circumstances, be prepared for potential stock price fluctuations in the near term. Nevertheless, assuming that current inflation trends endure, and the economy can hold its ground, stocks should continue to represent a key component of any diversified portfolio for long-term investors.
Talk with your wealth professional about your comfort level with your portfolio’s current mix of investments and discuss whether any changes are appropriate in response to an evolving capital market environment consistent with your goals, risk appetite and time horizon.
Note: The Standard & Poor’s 500 Index (S&P 500) consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The S&P 500 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. The Russell 2000 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.
Interest rates can affect stock markets in different ways. Frequently, when rates rise, equities are challenged because investors can choose to invest in bonds that pay more attractive yields than was previously the case, rather than stocks. Higher rates can put pressure on stock valuations, as corporations may need to generate more attractive earnings to capture investor interest. Another way the interest rate environment affects stocks has to do with companies’ bottom lines. If a debt-issuing company faces higher borrowing costs due to rising rates, it may result in reduced company profits, which can be reflected in lower stock prices. These factors are among the reasons why equity investors pay close attention to the interest rate environment.
If the Federal Reserve raises the short-term federal funds target rate it controls (as it did in 2022 and 2023), it can have a detrimental effect on stocks. A higher interest rate environment can present challenges for the economy, which may slow business activity. This could potentially result in lower revenues and earnings for a corporation, which could be reflected in a lower stock price.
There is not a direct correlation on the direction of interest rates stemming from stock market movement. The state of the economy and inflation are bigger factors that help determine the direction of interest rates. In many circumstances, interest rate movements can affect stock prices. The biggest impact stock prices have on interest rates is on the demand for bonds. If stock prices decline, it may indicate investors are seeking to reduce portfolio risk and putting more money to work in bonds. This reflects an increase in demand for bonds, which typically allows issuers to offer debt at lower interest rates.
With inflation retreating and interest rate cuts likely coming later this year, how should investors position their portfolios to capitalize on potential opportunities, while guarding against risks?
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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