Impact of Increasing Interest Rates on Stock Market
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Over the first half of 2022, the investment landscape underwent a significant transformation, mainly due to the soaring interest rates and persistent inflation. Stock markets didn't escape these changes, with a substantial "repricing" occurring in the stock market by June 2022. As a result, the S&P 500 stock index descended into a bear market, marking a 20% drop from its peak value.
To tame inflation, the Federal Reserve (Fed) implemented a major policy change early in the year, targeting a slower economic growth without causing a recession. However, the Fed's revised policy seemed to have had a considerable impact on the broader interest rate environment. For much of the year, bond yields showed an uptrend.
High interest rates have altered the investment landscape for equity investors, who had grown accustomed to a low-interest rate environment for an extended period. But what exactly is the relationship between interest rates and the stock market? Let's find out!
The Old "Easy Money" Policy from the Fed
The Fed's "easy money" policy was in place for nearly two years starting in early 2020. It has also persisted for a significant part of the past decade. This included maintaining the fed funds rates at a low level and increasing its bond market holdings. With the publication of COVID-19 in February and March 2020, the Fed rolled out essential easing measures. The Fed reduced the Fed funds target rate practically to 0% and increased its holdings in Treasury and mortgage-backed securities.
The result was low interest rates across the bond market. Fixed income investments became less attractive, making risk assets more appealing. Investors further out on the risk spectrum welcomed the Fed's "easy money" policy. Eric Freedman, the chief investment officer at U.S. Bank, states, "Supportive monetary policy was crucial for risk asset owners, regardless of whether it be in domestic equity, real estate, or cryptocurrency."
With this favorable policy in effect, the S&P 500 saw remarkable growth. It grew 18.40% and 28.71% in 2020 and 2021, respectively. Despite most of that period, the U.S. economy performed well, managing to recover from a sharp decline in the first half of 2020, attributed to COVID-19. The economy pushed ahead by 5.7% in 2021 (as measured by Gross Domestic Product), aiding the Fed in meeting its mandate of "maximum employment." Although the Fed claims that the goal is not easily quantifiable and can change over time, recent employment trends remain positive.
The milieu of widespread prosperity, low inflation, and interest rates has benefited equity investors. However, this situation may change as the Fed shifts its monetary policy after a sudden rise in inflation. The Consumer Price Index, a measure of living costs, climbed 7% in 2021. Subsequently, the Consumer Price Index recorded a 9.1% increase in inflation over the 12-month period ending June 2022, far exceeding the Fed’s goal of continued inflation within the 2% range for the long term.
The Fed's altered monetary policy has influenced the bond market. The U.S. 10-year Treasury note yield was 3.49% in June 2022, having jumped from 1.52% in 2021 to a peak of 3.49% in June 2022. In addition, the yields on the 3-month U.S. Treasury Bill (closely linked to the fed funds rates) increased from 0.06% at the end of 2021, ultimately reaching 2.5% by mid-July 2022.
How Higher Interest Rates Impact Equity Investment
Several reasons support the premise that interest rates could affect equity markets. One primary reason is that higher interest rates may have an impact on the future earnings growth of U.S. businesses. Freedman suggests that as the Fed tightens interest rates, the economic growth could slow down. In fact, the GDP growth rate fell in the first half of 2022, with an annual rate of decline by 1.6% in Q1.
Freedman mentions that "The Fed has intimated a continuous rise in interest rates." In this environment shaped by the Fed's "easy money" period before 2022, stocks have lost some appeal. Bonds, certificates, and deposit vehicles now offer higher yields, intensifying competition for stocks. Rob Haworth, senior financial strategy director at U.S. Bank Wealth Management, notes that if interest rates rise, stock investors will be less enthusiastic about buying stock prices. The value of future earnings will become less appealing than bonds offering more competitive yields. Anticipated higher rates in the future will reduce the stock's present value. This could exert additional pressure on stock prices.
Haworth points out that stocks with high price-to-earnings multiples have been hit hardest. The most significant price drops have affected stocks that appear overvalued, such as technology and secular growth companies, which have been strong since the pandemic. Haworth notes that stocks with low current earnings had their stock prices surge prior to the Fed changing its policy; investors were more focused on future earnings. In a rising interest rate environment, markets are less likely to "pay up" for unprofitable stocks.
Source:https://www.usbank.com/investing/financial-perspectives/market-news/how-do-rising-interest-rates-affect-the-stock-market.html#:~:text=%E2%80%9CIf%20interest%20rates%20move%20higher,at%20U.S.%20Bank%20Wealth%20Management
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Fun Fact: Did you know? The term "bull market" originated from medieval Europe, where bulls were aggressive and symbolized upward swings, while bears, with their downward swipes, signified downturns. Although bulls are less destructive than bears, in the context of investing, a "bear market" sends shivers down investors' spines!
- The Federal Reserve's intention to combat inflation by tightening monetary policy has led to a strong increase in interest rates, giving bond investments more appeal over stocks, creating competition for equity investors.
- In 2022, the stock market had undergone a substantial repricing due to soaring interest rates and persistent inflation, pushing the S&P 500 index into a bear market with a 20% drop from its peak value.
- The relationship between interest rates and the stock market shows that as interest rates rise, the growth of U.S. businesses, consumer spending, and economic growth may slow down, ultimately leading to a lower value of future earnings and pressure on stock prices.
- Investors should remain vigilant of financial trends amidst the shifting monetary policy and the impact it has on equity investing in the stock market, as well as other investments such as fixed income and real estate.
