How do rising interest rates affect the stock market?

Equity investors are weighing the impact of a stronger-than-expected economy with the ongoing challenges of higher inflation and rising interest rates. Over the first seven months of the year, stocks regained most of the losses incurred during 2022’s bear market, gaining 19.5%. However, stocks were down again in August and September, declining approximately 6% in that two-month period (through September 22).¹ During its seven-month rally, the bulk of the market’s favorable returns were generated by a handful of key sectors, most associated with technology-oriented companies.

Source: WSJ.com. Chart depicts daily changing values of the Standard & Poor’s 500 Index, an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.

Inflation surged last year, peaking at 9.1% for the 12-month period ending June 2022. The Federal Reserve (Fed) sought to ease inflation with monetary policy moves, which included increasing the short-term target federal funds rate while at the same time reducing its bond holdings, removing significant liquidity from the fixed-income market. The Fed’s moves are designed to slow the rate of economic growth, with the goal of lowering inflation, ideally without tipping the economy into a recession.

What should in investors expect in a higher interest rate environment? How do today’s higher rates impact your own financial plan?

Higher rates alter equity market landscape

There are various reasons why increasing interest rates can have an impact on equity markets. For example, it could affect future earnings growth for U.S. companies. “As the Fed tightens interest rates, we can expect slower economic growth,” says Freedman. In fact, GDP expanded at a considerably slower pace in 2022, growing at 2.1% (compared to 5.9% in 2021). The consensus view of many economists was that the U.S. was headed for a recession in 2023. However, in the year’s first half, the economy appeared to stabilize, generating annualized growth rates of 2.0% in the first quarter, and a 2.1% in the second quarter.² While the economy’s continued expansion was encouraging, a reduced rate of growth resulted in a slowdown in corporate earnings over the year’s first two quarters.

“It’s clear that the Fed policy shift created great change in the markets,” says Bill Merz, head of capital market research at U.S. Bank Wealth Management. Merz notes that the Fed faces a difficult balancing act, trying to temper growth sufficiently to tamp down inflation without causing a recession. The U.S. Bank economics team forecasts that a recession will be narrowly avoided this year.

Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management, expects earnings growth to improve in the second half of the year, but not without some challenges. “Companies that issued debt to raise capital when interest rates were low may start to see those issues reach maturity,” says Haworth. “That could require them to refinance debt at today’s higher interest rates as existing debt comes due.” Higher interest costs have the potential of cutting into corporate profits, but Haworth says it's not clear how significant the impact will be, as some companies may not be required to take on more debt given their healthy balance sheets.

Another reason rising interest rates can create a more challenging environment for stocks is that bonds, certificates of deposit and other vehicles pay more attractive yields. “If interest rates move higher, stock investors become more reluctant to bid up stock prices because the value of future earnings looks less attractive versus bonds that pay more competitive yields today,” says Haworth. “Present value calculations of future earnings for stocks are tied to assumptions about interest rates or inflation. If investors anticipate higher rates in the future, it reduces the present value of future earnings for stocks. When this occurs, stock prices tend to face more pressure.”

“Most of the hardest hit stocks in 2022 were 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. Persistently elevated interest rates may change the outlook for stocks carrying valuation premiums, according to Haworth. “The recent runup in stock prices pushed price-to-earnings multiples higher on a number of these same stocks that benefited from the low interest rate environment. If future earnings can’t live up to expectations, market multiples will have to come down, which could cause these stocks to lose value.” This represents a risk for a portion of the equity market that benefited the most from 2023’s first-half rally.

A cloudy outlook

While the Fed held the line on interest rates at its September 2023 meeting, it left the door open for at least one more rate hike in 2023. More important, Fed Chair Jerome Powell stated that rates will remain elevated for a period of time. According to Powell, “it would not be appropriate to cut rates and we won’t cut rates,” at least for now.³

“The Fed is very focused on achieving its long-term inflation target of 2% (inflation stood at 3.7% for the 12-month period ending in August⁴),” says Freedman. “The Fed’s desire to achieve greater price stability may come at a cost to parts of the economy, but it’s a cost the Fed appears willing to endure.”

It should be noted that a changing interest rate environment, while creating more headwinds for stocks, doesn’t eliminate potential upside opportunity. “The key is how well companies perform,” says Haworth. “One of the variables we’re watching is whether the declining inflation rate results in stock valuations appearing more reasonable.” Haworth notes that a return to lower inflation would generally benefit stocks.

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.”

Putting your portfolio into perspective

As you assess your own circumstances, it’s fair to anticipate that equity markets may continue to exhibit price volatility in the near term. Nevertheless, assuming that current inflation trends endure, and the economy is able to hold its ground, stocks should continue to represent a key component of any balanced portfolio for long-term investors.

Talk with 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 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.