Key takeaways
Equity investors appear to be most focused on factors such as the economy and corporate earnings, though Federal Reserve (Fed) interest rate policy is also a consideration.
Market gains across the S&P 500 generally broadened out during the summer of 2024.
The stock market is proving to be particularly volatile in the days leading up to the anticipated start of Fed rate cuts.
As equity investors weigh what appears to be an easing interest rate environment, much of the focus has turned to fundamental factors such as economic signals and corporate earnings. Anticipation of pending Federal Reserve (Fed) interest rate cuts has had a clear bond market impact, but a variety of factors may be at play in equity markets.
“Recent stock market volatility reflects investors choosing to pursue safe haven trading,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Money seemed to flow out of what had been high-flying technology stocks, with investors seeking less volatility by shifting to greater bond market concentrations.”
“Recent stock market volatility reflects investors choosing to pursue safe haven trading,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Money seemed to flow out of what had been high-flying technology stocks, with investors seeking less volatility by shifting to greater bond market concentrations.”
A temporary “flight to safety” was evident during September’s opening week, as the S&P 500 retreated by more than 4% over the course of four trading days. The technology-heavy NASDAQ Composite Index lost 5.7% over the same period. Markets stabilized the following week, but Haworth says it primarily reflected investor concerns over the economy’s direction.
“The market is trying to determine how quickly the economy may be slowing. Will slower job growth eventually begin to turn into more layoffs? Is inflation firmly under control, allowing the Fed to more aggressively cut interest rates to stabilize the economy?” Haworth says these are among the uncertainties clouding today’s investment environment.
The September downturn came after U.S. stocks posted solid gains in August. By the end of August, the S&P 500’s year-to-date return climbed to 19.5%.1 For much of the year, large-cap stocks have outpaced mid-cap and small-cap stocks. “One factor driving this trend is the impact of higher financing costs, directly related to today’s elevated interest rates,” says Haworth. “This disproportionately affects smaller companies that have limited cash reserves and need to issue debt more frequently.” Elevated borrowing costs can chip away at a company’s profitability.
Haworth says although rates remain high, companies are under less pressure. “The market adapted to current interest rates, and is prepared for the next move in rates to be lower.”
The stock market’s sharp 2022 downward turn began after the Fed initiated a series of increases in the short-term federal funds target rate it controls. That resulted in the rate moving from near 0% in early 2022 to a range of 5.25% to 5.50% following the Fed’s last rate hike in July 2023. While the Fed has held rates steady since, it’s laid the groundwork to begin cutting the federal funds rate banks charge each other for overnight lending. Markets now anticipate a series of Fed interest rate cuts as 2024 winds down.2
How are interest rates likely to impact the stock market going forward?
Fed interest rate moves tend to be a signal to bond investors, and beginning in 2022, yields on bonds across the board rose as the Fed raised rates. In recent months, the trend reversed. Yields on key benchmarks such as 10-year and 2-year Treasury notes have dropped by 1% or more from their 2024 peaks.3 These changes reflect the market anticipating Fed rate cuts.
What may drive markets from here, says Haworth, is how the Fed approaches interest rate policy in the months ahead. Haworth is particularly interested in forecasts from the policy-making Federal Open Market Committee (FOMC). “The key question is where the FOMC projects the fed funds rate is headed as they consider future rate cuts. Rates are certainly headed lower, but the interest rate they determine to be a “neutral” rate (compared to today’s elevated rates) may have an impact on equity markets.”
Haworth says if the fed funds rate ultimately settles in at a level above the inflation rate, fixed income investments will continue to attract investors. “That environment may become more challenging for growth stocks as investors shift more assets into safer segments of the market.”
“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. “Higher rates mean investors are inclined to pay less for a dollar of future earnings in a company because they can earn more competitive current yields in lower volatility investments like cash and bonds,” says Haworth. “In 2023, as interest rates appeared to be approaching peak levels for this cycle, markets shifted.” As a result, after underperforming small-cap stocks in 2022, large-cap growth stocks far outpaced small stocks in 2023 and started 2024 in an even stronger position. As interest rates fell, it signaled that smaller companies might face potentially lower borrowing costs. As a result, in July 2024, smaller stocks started to outperform large-cap growth stocks. This chart compares performance of large-cap growth stocks (S&P 500 Growth) and small-cap stocks (Russell 2000 Index).
While interest rate trends can influence the stock market, recent performance appears to be more closely tied to perceptions on the U.S. economy’s trajectory. “As the Fed raises interest rates, we typically expect slower economic growth,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. Surprisingly, however, U.S. gross domestic product (GDP) grew more quickly in 2023 (2.5%) than it did in 2022 (1.9%). Growth slowed modestly to an annualized 1.4% rate in 2024’s first quarter, but gained momentum again in the second quarter, growing at an annualized pace of 3%.4 “Consumer spending and business capital expenditures remain strong, and that’s a reason for bullishness about stocks in the near term,” says Freedman.
Continued growth in corporate earnings (profits) is another factor contributing to generally favorable investor sentiment. 2024’s second quarter was the fourth consecutive quarter of S&P 500 profit 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 and 2024. When bond yields rose, stock prices retreated, and when rates fell, stocks typically reacted favorably.
Flat or declining bond yields may have some ramifications for stocks, but that’s not the only factor equity investors should consider. “Interest rates may continue falling as inflation softens,” says Haworth. “A key factor is whether inflation declines because the economy stalls, or if it is a matter of prices softening within the context of a still-growing economy.” Haworth says the latter scenario is more beneficial for equities.
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. “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 more interest rate cuts likely coming, 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.
Equal Housing Lender. Deposit products are offered by U.S. Bank National Association. Member FDIC. Mortgage, Home Equity and Credit products are offered by U.S. Bank National Association. Loan approval is subject to credit approval and program guidelines. Not all loan programs are available in all states for all loan amounts. Interest rates and program terms are subject to change without notice.
