How do rising interest rates affect the stock market?

Interest rates have remained persistently high throughout 2023. Through July, the Federal Reserve (Fed) continued to bump up the short-term interest rate it controls, the federal funds target rate – setting it to a range of 5.25% to 5.50%. As a result, yields across the bond market are higher as well. In contrast, equity markets responded with three consecutive months of declines (August through October).

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, returning more than 20%. However, stocks gave back nearly half of those gains between August and October.¹ Year-to-date, 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 Fed’s interest rate hikes were designed to slow the economy and ease inflation. The Fed's goal is to bring inflation, which peaked at 9.1% in mid-2022, closer to its goal of 2%, without tipping the economy into a recession. As of September 2023, inflation stood at 3.7% for the previous 12-month period.² With inflation still considered higher than historical averages, interest rates may remain elevated for an extended period of time.

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 typically expect slower economic growth,” says Eric Freedman, chief investment officer, U.S. Bank Asset Management Group. Surprisingly, however, Gross Domestic Product (GDP) maintained a modest rate of growth (about a 2% annualized pace) in 2022 and in the first half of 2023. GDP expanded at a 4.9% annualized rate in 2023’s third quarter.³ The economy’s continued growth in the face of rising interest rates was due in large part to strong consumer spending, fueled by higher-than-average wage growth.

“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. To this point, the Fed has managed to accomplish just that.

Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management, notes that modest corporate earnings growth occurred in 2023’s third quarter, but it’s not all smooth sailing for U.S. corporations. “Generally speaking, larger companies don’t have a great need to issue new debt, either because they were able to obtain financing when interest rates were lower or because they have sufficient earnings to fund growth needs.” says Haworth. “However, smaller companies may be in a position where they need to reissue debt, and therefore will face higher interest costs, or else choose to delay making major investments until rates come down.” Haworth also notes that utility and real estate companies are sensitive to higher interest rates and face more financial obstacles as a result.

Another reason rising interest rates can create a more challenging environment for stocks is more attractive yields for bonds, certificates of deposit and other vehicles. “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.”

Stocks have, at times, rallied during periods when interest rates fell back. Then, when rates moved higher, stocks have typically retreated. “Bond yields have moved up and down over the course of 2023,” says Haworth. “We don’t necessarily yet see a discernible trend indicating a peak in bond yields or that stocks are poised for a sustainable rally.” Haworth still anticipates a continuation of the kind of market volatility that’s existed since mid-summer. “Inflation has to be tamed before we see the Fed make any significant reductions to interest rates, which would likely ease concerns for equity investors.”

A cloudy outlook

While the Fed held the line on interest rates at its September and November 2023 meetings, it hasn’t eliminated the possibility of at least one more rate hike this year. Fed Chair Jerome Powell also stated after November’s meeting that the monetary-policymaking Federal Open Market Committee (FOMC), “is not thinking about rate cuts right now at all.”⁴

“The Fed is very focused on achieving its long-term inflation target of 2% (well below the current rate of 3.7%),” 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 companies’ financial performance,” 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.