How Do Rising Interest Rates Affect the Stock Market? | U.S. Bank

How do interest rates affect the stock market

key points

  • a changing interest rate environment contributed to headwinds for the stock market.
  • major policy change by the federal reserve took liquidity out of markets and led to a revaluation of risky assets, such as equities.
  • With rates remaining elevated, equities may continue to face a volatile environment in the coming months.

The investment landscape underwent a notable change in the first half of 2022, highlighted by a significant increase in interest rates and a persistent increase in the rate of inflation. While this had a clear impact on fixed income investments (bonds decline in value when interest rates rise), equities were not immune to the effects of the changing environment. by June 2022, a significant “revaluation” occurred in the stock market, and the standard & poor 500 stock index, a key indicator for us shares, fell in a bear market, representing a 20% drop from its peak value.

The Federal Reserve (Fed) tried to ease the threat of inflation by initiating a drastic policy change earlier in the year. The Fed’s moves are designed to slow the rate of economic growth, ideally without pushing the economy into a recession. the revised federal policy appeared to have a major impact on the broader interest rate environment. bond yields trended higher for much of the first half of the year.

rising interest rates altered the landscape for equity investors who became accustomed to an environment in which interest rates remained low for an extended period. what does this mean for the stock portion of your portfolio?

the fed’s earlier “easy money” stance

For a two-year period dating back to early 2020 and for much of the previous decade, the Federal Reserve followed what is called an “easy money” policy. This includes keeping the fed funds rate fairly low and expanding its holding balance in the bond market. the federal reserve took major easing steps when covid-19 first emerged in february and march 2020. it lowered the fed funds target rate to nearly 0% and increased its holdings of mortgage-backed debt securities and the treasure.

“As the Federal Reserve tightens interest rates, we can expect a slowdown in economic growth.”

– eric freedman, chief investment officer, us. uu. banking and institutional wealth management

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This helped keep interest rates low in the bond market. risky assets became more attractive. This is due, at least in part, to the reality that investors were unable to earn attractive returns on fixed income investments.

Investors further down the risk spectrum favorably viewed the Federal Reserve’s so-called “easy money” policy. “Supportive monetary policy was critical for owners of risky assets, whether it be domestic stocks, real estate or cryptocurrencies,” says Eric Freedman, US chief investment officer. uu. bank. In 2020 and 2021, the S&P 500 gained 18.40% and 28.71%, respectively.

The US economy also performed well for most of this period. after a significant drop in the first half of 2020 (linked to the covid-19 outbreak), the economy proved resilient. in 2021, the economy grew by 5.7% measured by gross domestic product (gdp), it is the calendar year with the highest growth since 1984.1 which helped the fed to advance in the fulfillment of one of its mandates, to achieve the “maximum employment” in the economy. Although the Federal Reserve states that this target “is not directly measurable and changes over time,” employment trends remain positive today.2 For most of the past four decades, inflation and interest were relatively low. it is an environment that tends to favor equity investors. the question for the future is to what extent circumstances can change.

a sudden increase in the rate of inflation prompted the decision of the Federal Reserve to modify its monetary stance. in 2021, the cost of living measured by the consumer price index increased by 7%. Inflation for the 12-month period ending June 2022 reached 9.1%, the highest annual cost-of-living increase since 1981.3 This far exceeds the Fed’s goal of keeping annual inflation in the range of 2% long-term.

changes in the bond market reflect the change in federal reserve policy. US 10-Year Yield the treasury note, a broader bond market benchmark, rose from 1.52% at the end of 2021 to a high of 3.49% in June 2022. the treasury bill (more closely related to the rate of fed funds) jumped from 0.06% in late 2021 to 2.5% in mid-July 2022.

higher rates alter the stock investment landscape

There are several reasons why rising interest rates can have an impact on stock markets. One is that it could affect future earnings growth for the US. uu. companies. “As the Federal Reserve tightens interest rates, we can expect a decline in economic growth,” Freedman says. in fact, gdp growth slowed in the first half of 2022, even falling to an annualized rate of 1.6% in the first quarter of the year.

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“the federal reserve has telegraphed its intention to raise interest rates even higher,” says freedman. In this environment, equities have temporarily lost some of the appeal they had during the fed’s “easy money” period prior to 2022.

One reason for the change is that as bonds, certificates of deposit and other vehicles pay more attractive yields, it could create more competition for stocks. “If interest rates go up, stock investors become more reluctant to raise stock prices because the value of future earnings will look less attractive compared to bonds that pay more competitive yields today,” says Rob Haworth , senior director of investment strategy for u.s. bank asset management. Calculations of the present value of future stock earnings are tied to assumptions about interest rates or inflation. If higher rates are anticipated in the future, the present value of the stock’s future earnings is reduced. if this occurs, it can put further pressure on stock prices.

“The hardest hit stocks have been primarily those with premium price-earnings (P/E) multiples,” Haworth says. In other words, stocks that are considered “expensive” from a valuation perspective suffered the biggest price declines. this included technology and secular growth companies that have enjoyed extremely strong performance since the pandemic began. Haworth points out that before the Fed’s policy change, several stocks that generated little or no current earnings saw their share prices inflate as investors focused on future earnings potential. “Markets are not as likely to ‘pay’ for stocks that can’t generate significant gains if interest rates continue to rise,” says Haworth.

a less predictable environment

One of the biggest questions is how far the Federal Reserve will have to tighten its monetary policy to curb inflation. When the inflation rate first jumped above the 5% level in May 2021, federal officials indicated they thought it was a temporary move that would correct itself. however, elevated inflation rates proved more persistent and the fed felt her hand was forced.

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“It’s clear that the fed’s policy change created a big shift in the markets,” says bill merz, senior vice president and senior portfolio strategist at u.s. bank asset management. “2022 is very different from 2021. The potential for volatility in the capital markets remains high and the range of possible outcomes is wide.” Merz notes that the Fed faces a difficult balancing act, trying to moderate growth enough to tamp down the threat of inflation without causing a recession.

It should be noted that a changing interest rate environment, while creating more headwinds for equities, does not mean there are no continued upside opportunities. “The key is how well companies will perform through the rest of 2022 and early 2023,” Haworth says. “An important question is whether earnings expectations are lowered. that hasn’t happened until mid-2022, but if it did, that could result in further pressure on stocks.” A key earnings variable is whether companies can raise the prices of their goods and services enough to keep pace with rising costs reflected in the high rate of inflation. another is whether the economy avoids a recession. a struggling economy would likely detract from corporate earnings and create more risk for the stock market.

There is reason to be prepared for the prospect of a further revision in asset prices similar to the one that propelled equities into bear market territory in the first half of the year. A key variable likely to influence markets will be how aggressively the Federal Reserve raises interest rates.

putting your portfolio in perspective

As you assess your own circumstances, it may be wise to maintain lower expectations for short-term stock market performance. however, assuming the Fed manages to moderate inflation and the economy recovers, stocks will remain well positioned over the long term. At the same time, it’s important to be prepared for the potential for continued market volatility.

Speak to your wealth professional about your current comfort level with your portfolio’s investment mix and discuss whether any changes are appropriate in response to an evolving capital market environment.

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