How do rising interest rates affect the stock market?

March 4, 2022 | Market news

Significant events have had an impact on the investment environment over the past two years. A rapid economic recovery following the initial setback suffered in the early days of COVID-19 resulted in a significant jump in the inflation rate. This led to a major shift in monetary policy from the Federal Reserve (the Fed) that could drive interest rates higher in 2022. After the Fed laid out its plans, including interest rate hikes, a new complication arose – Russia’s military invasion of Ukraine that began in late February and has reverberated around the world since. Along with the severe human toll the war is taking, there are significant economic implications as well that could have a global impact. Western nations have allied to try to place significant economic pressure on Russia through a variety of sanctions. It serves as a non-military method of intervention to convince Russia to pull back from its current course of action.

At the same time, the Fed has signaled that it remains on track to implement a series of steps to try to temper the inflation threat. The result of these actions will likely result in higher interest rates — seen as a way to help achieve more balance between supply and demand in the economy and ultimately slow growth to the cost-of-living. Fed Chairman Jerome Powell admits that, “The near-term effects on the U.S. economy of the invasion of Ukraine, the ongoing war, the sanctions and of events to come remain highly uncertain.” And while Powell remains steadfast that the Fed will follow through with its stated plan to begin raising short-term interest rates, he added “we will proceed carefully as we learn more about the implications of the Ukraine war on the economy.”1

While rising interest rates usually create challenges for bond investors (higher rates typically mean declining values for prices of existing bonds), it can make the environment more challenging for stock investors as well.

In response to the economic fallout from the initial emergence of COVID-19 in early 2020, the Fed cut the short-term interest rate it controls, the federal funds target rate, to near 0%. At the same time, the Fed actively invested $120 billion per month, spread among U.S. Treasury bonds and mortgage-backed securities, in an effort to help keep long-term interest rates low. These moves were designed to spur investment and move the economy forward.

The Fed’s so-called “easy money” policy was looked upon favorably by investors farther out on the risk spectrum. “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.

Economic forces indicate a changing environment

The economy showed robust growth dating back to mid-2020, generating a gain of 5.7% in 2021 as measured by Gross Domestic Product (GDP).2 That helped the Fed make progress in meeting one of its mandates, to achieve “maximum employment” in the economy. While the Fed states that this goal “is not directly measurable and changes over time,” employment trends since early 2020 have been positive.3 What may be more critical to the Fed’s decision to alter its monetary stance is the direction of inflation. In 2021, the cost-of-living as measured by the Consumer Price Index rose 7%, its highest reading in approximately four decades.4

Given that the Fed seeks to maintain annual inflation in the range of 2% over the long term, the sudden surge in living costs appeared to prompt the Fed to end its bond buying program by early 2022 and begin raising the fed funds rate, with promises of more rate increases in the months to come.

The combination of the Fed eliminating its asset purchases and raising interest rates is likely to impact various segments of the bond market. The yield on the 10-year U.S. Treasury note, a benchmark of the broader bond market, rose from 1.52% to 1.79% in the first month of 2022. Notably, the yield on the 10-year Treasury was less than 1% at the end of 2020. While 10-year T-note rates below 2% are still considered historically low, the environment has changed considerably in the past year.

“2022 is shaping up to be very different from 2021. The potential for volatility in the investment markets is high and the range of possible outcomes is wide.”

For the better part of the past four decades, inflation and interest rates have remained relatively low. This type of environment tends to work in favor of equity investors. The question going forward is the degree to which circumstances may change.

Higher rates alter the 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. “If the Fed tightens interest rates enough to a point where the inflation rate falls, we may also experience a decline in economic growth,” says Freedman. He expects that the rate of corporate earnings growth will slow as a result, which was likely a factor in the stock market’s retreat in the opening weeks of 2022.

“Based on recent Fed statements, we may see a number of rate hikes in the coming year,” says Freedman. “If this is the case, the market may feel it’s necessary to re-price assets to reflect a less attractive environment for stocks.”

In recent times, with interest rates on long-term bonds near historically low levels, many investors saw little choice but to put money to work in stocks. However, if the environment changes and bonds, certificates of deposit and other vehicles pay more attractive yields, it could create greater competition for stocks. “If interest rates suddenly moved higher, stock investors might be more reluctant to bid up stock prices because the value of future earnings will look less attractive versus bonds that pay more competitive yields,” 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, present values of future earnings for stocks look less attractive. If this occurs, it may put more pressure on stock prices.

“If inflation remains higher, the hardest hit stocks are likely to be those with premium price-to-earnings (P/E) multiples,” says Haworth. In other words, stocks that are considered “pricey” from a valuation perspective are the most vulnerable to a setback. This includes secular growth and technology companies that enjoyed extremely strong performance since the pandemic began. Many of those stocks already suffered setbacks in late 2021 and early 2022. Haworth notes that prior to the Fed’s policy shift, a number of stocks that had limited growth and little to no 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 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 (raising interest rates, reducing assets invested in the bond market) to put the clamps on 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 is creating a year of great change in the markets,” says Bill Merz, senior vice president and senior portfolio strategist at U.S. Bank Wealth Management. “2022 is shaping up to be very different from 2021 [a year when the S&P 500, a benchmark of stock market performance, gained nearly 29%]. The potential for volatility in the investment markets is 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. “We don’t anticipate a recession resulting from the Fed’s actions,” says Merz. “But we expect more volatility as the Fed tries to manage this process.”

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 in 2022,” says Haworth. “Inflation and higher borrowing costs could dampen earnings, but so far, companies have demonstrated that they have pricing power in this market. The ability to raise prices could help a number of companies maintain solid earnings growth, which should benefit their stock prices.” Haworth adds that “as dour as we can paint the picture for stocks in a rising interest rate environment, there are reasons to think this market continues to grow even with increased volatility.”

One trend that Haworth anticipates will re-emerge in 2022 is companies buying back shares of their own stock. He notes that share repurchase activity was down in 2020 and 2021. “If more companies redeploy earnings to purchase shares of stock and reduce the number of shares outstanding in the market, that tends to support growth of earnings-per-share over time,” according to Haworth.

Putting your portfolio into perspective

As you assess your own circumstances, it may be wise to lower expectations for equity market performance in the near term, especially compared to the double-digit returns that have become common. Nevertheless, if the economy continues to grow, stocks remain well positioned to generate positive returns. At the same time, it’s important to be prepared for the potential of increased volatility in the markets.

Talk to your wealth professional about your current comfort level with your portfolio mix and discuss whether any changes are appropriate in response to what appears to be an evolving market environment.

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