Key takeaways
Solid economic growth and strong corporate earnings continue to bolster stock prices despite higher interest rates.
The Fed’s indication that it may reduce interest rates in 2024 appears to be fueling positive investor sentiment.
Investors watched already-elevated interest rates move higher in 2024’s opening months. The trend reflected data showing the U.S. economy remains resilient. While favorable economic news tended to drive expectations that inflation might remain higher for an extended period of time, stocks generally moved in a positive direction. U.S. stocks, as measured by the benchmark S&P 500, gained more than 10% in the first quarter. In April a portion of those gains were relinquished, but stocks again moved on an upward path in early May.1
“Underlying fundamentals remain generally positive for stocks,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Stocks may be somewhat expensive from a valuation perspective, but if economic expansion continues and earnings grow as they have recently, higher valuations can persist for some time.”
To this point, investors are somewhat caught in the middle, buoyed by solid economic and earnings data, but anxious about the direction of interest rates. Much of their focus is on Federal Reserve (Fed) interest rate policy. After the Fed triggered 11 increases in the short-term federal funds target rate it controls, it signaled its intentions to cut rates in 2024. However, Fed officials also indicated that more convincing evidence that inflation is under control is required before it makes its first rate cut.2
How are interest rates likely to impact the stock market over the course of 2024?
The Fed plays a role in managing key components of the U.S. economy, including moderate inflation, full employment and a modest level of long-term interest rates. In March 2024, inflation over the previous 12 months stood at 3.5%, much lower than its mid-2022 peak of 9.1%, but not yet down to the Fed’s 2% target.3 Fed officials are concerned that inflation has not managed to yet dip below 3%; it has stayed in a range slightly above 3% since mid-2023.
Haworth says markets are anxious to see the Fed’s policy provide an equity market boost. “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. 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. Recent stock market volatility may be tied to evolving investor speculation about rate cuts’ starting date.
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 is a bigger concern than it is for 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).
Stock market leadership, previously concentrated in technology stocks, seems to be broadening. “There’s still a lot of room for the market's strength to broaden out to more sectors,” says Haworth. For example, he points out that the Utilities and Real Estate sectors are highly interest-rate sensitive and likely to benefit once rates begin to decline.
While interest rate trends influence 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, the U.S. gross domestic product (GDP) grew more quickly in 2023 (2.5%) than it did in 2022 (1.9%). Growth slowed modestly to 1.6% in 2024’s first quarter.4 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 corporate earnings grew in 2023’s final two quarters and appear to be on the same path in 2024’s first quarter. He expects investors to increasingly emphasize factors such as how fast companies expand business activity 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 Fed held the line on rates after its last rate hike in July 2023. After its April 30-May 1, 2024, meeting, Fed Chair Jerome Powell indicated that rate cuts are still on the Fed’s radar, but the timing of such cuts remains a question.5 “The Fed is very focused on achieving its long-term inflation target of 2% (still below the current rate of 3.5%),” says Freedman.
“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.
While market interest rates may fluctuate 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. The U.S. Bank Asset Management Group currently recommends an overweight position in equities. “In part, this is due to the fact that equity returns can help investors keep pace with inflation,” says Haworth.
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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