Stock markets are going through a difficult time right now due to changes in the underlying economy. A large portion of the financial markets, including the stock market, experienced headwinds as a result of rising interest rates and persistently high inflation.
Beginning in 2022, there was a significant “repricing” in the stock market, and the Standard & Poor’s 500 stock index—a crucial gauge of U.S. equities—as well as other significant market indices—entered a bear market, reflecting a loss of 20% from their peak values.
Through its monetary policy decisions, the Federal Reserve (Fed) tried to lessen the possibility of inflation. These actions included lowering its bond holdings and sharply raising the short-term target federal funds rate from almost zero percent to 4.50% to 4.75% by February 2023. The Fed’s policies aim to slow the economic growth rate, preferably without sending the economy into a recession.
Rising interest rates changed the scene for equity investors accustomed to an extended low interest-rate environment. How do rising interest rates affect the economy and your stock positions?
The Fed’s previous “easy money” stance
The change in the underlying stock market environment stands in strong contrast to the relatively positive economic landscape that stretched back to the waning days of the financial crisis in 2009. Low-interest rates and mild inflation were the norms for most of those ten years. Stocks and other risky assets prospered in such a situation. Whether they were investing in domestic equities, real estate, or cryptocurrencies, risk asset owners needed supportive monetary policy, according to U.S. Bank Chief Investment Officer Eric Freedman. Impressive increases of 18.40% in 2020 and 28.71% in 2021 were seen on the stock market.
The Gross Domestic Product (GDP) indicator for the U.S. economy showed positive growth for most of this time, reaching its greatest annual growth rate since 1984 in 2021 with a 5.9% growth rate. 1 That aided the Fed in moving closer to achieving “maximum employment” in the economy, one of its goals. The employment landscape is still improving.
Most of the last four decades had relatively modest inflation and interest rates. Although volatility was occasionally a problem, equities investors saw a largely beneficial experience during this time. The extent of potential change is the question at hand moving ahead.
Inflation’s resurgence tips the scales
A rapid spike in inflation caused the Fed’s monetary policy to alter. The Consumer Price Index (CPI) showed an increase in the cost of living of 7% in 2021. Inflation over the 12 months that ended June 2022 reached 9.1%, the most significant increase in yearly living costs since 1981. Since then, the inflation rate has decreased but is still high; the CPI for the year ending in January 2023 was 6.4%. 3 This substantially exceeds the Fed’s long-term target of keeping annual inflation in the neighborhood of 2%.
The Fed’s change in policy is reflected in changes in the bond market. A benchmark of the larger bond market, the 10-year U.S. Treasury note yield increased from 1.52% at the end of 2021 to more than 4% in October 2022, marking its highest level in over a decade. 4 From 0.06% at the end of 2021 to 4.86% by February 2023, the 3-month U.S. Treasury bill yield— more closely connected to the fed funds rate—rose sharply.
Higher rates alter the equity investment landscape
Increasing interest rates may affect equities markets for a variety of reasons. One is that it might impact American companies’ future earnings growth. According to Freedman, we can anticipate a slowdown in economic growth when the Fed raises interest rates. In actuality, 2022 saw a marked slowdown in GDP growth, rising by only 2.1% (as opposed to 5.9% in 2021).
Bonds, certificates of deposit, and other investments offer more attractive yields, another factor contributing to stocks underperforming as interest rates climb. Rob Haworth, senior director of investment strategy at U.S. Bank Wealth Management, the value of future earnings appears less attractive compared to bonds that offer more competitive yields today.
As a result, stock investors become less willing to bid up stock prices. “Assumptions about interest rates or inflation are incorporated into present value projections of future stock earnings. The present value of future earnings for equities is decreased if investors anticipate higher rates in the future. When this happens, the pressure on stock prices usually increases.
The majority of the firms with premium price-to-earnings (P/E) multiples have been the hardest hit, according to Haworth. In other words, stocks deemed “pricey” in terms of valuation experienced the most significant price drops. This includes businesses with secular growth and tech firms that have performed incredibly well since the pandemic started.
According to Haworth, previous to the Fed’s change in policy, several stocks with low to no current earnings soared in price as a result of investors focusing on the possibility of future earnings. As interest rates continue to rise, Haworth contends, “markets are less likely to ‘pay up’ for stocks that are unable to provide considerable present earnings.
Haworth adds that greater debt expenses (caused by high-interest rates) might reduce company profitability as another aspect that poses difficulties for equities markets. Companies that must roll over debt must pay more for such debt in today’s market. Haworth claims that this raises the potential of future diminishing corporate earnings. Stock prices generally decline when earnings do.
Putting your portfolio into perspective
Equities markets may continue to see price volatility in the short term as you evaluate your situation. Yet, stocks are still in a strong position over the long term, provided the Fed successfully tames inflation and the economy eventually rebounds.
