Interest rates have been a major talking point for both investors and economists over the past several months. In fact, the Fed has already raised rates twice in 2022 and many pundits project several more rate increases this year. So, many investors are wondering how these higher rates could impact their portfolios.
There are many factors that impact the pricing of certain assets, including stocks. But interest rates can have an especially significant impact on certain stock sectors, and the economy as a whole. Understanding how the economy and stocks typically react when interest rates are on the rise can help you make the most of rising rates.
How Do Rising Interest Rates Impact Stock Prices?
Stock prices are dependent on many factors, such as the current profitability of the company, the estimated future success of the firm, and consumer expectations for both the industry and the economy. Interest rates can impact each of these factors.
Higher Rates Can Raise Business Costs and Lower Profitability
When the FOMC raises the Fed funds rate – the rate at which banks borrow money from each other overnight – it costs financial institutions more to borrow for their short-term needs. In response, they tend to raise the rates they charge to their customers. This can translate to higher mortgage, car loan, and credit card rates. In addition to higher rates for consumer credit, rates for business loans typically increase as well.
When consumers pay more for financing, they have less disposable income to spend on products and services. This can lead to lower discretionary spending, and therefore lower sales for some businesses. Additionally, when businesses pay more for financing, it can raise the cost of doing business.
As consumers purchase fewer goods, and businesses pay more for financing, it can negatively impact both company profits and economic output. So, when the FOMC raises the Fed funds rate, it can have a ripple effect throughout the economy and the stock market.
Stock Valuations are Heavily Impacted by Rates
Another factor that impacts stock prices is the value of estimated future cash flows. Often, a discount valuation of earnings model is used to determine the fair price for a stock. This calculation is especially useful for growth stocks, which tend to have higher estimates for future cash flows compared to their current income.
The discount model estimates a business’ future income and then discounts that figure using a formula. A key component of that formula is the risk-free rate, or the market interest rate when there is no term or credit risk. Commonly, the 3-month Treasury yield is substituted for the risk-free rate in these calculations because of its short time horizon and relative safety.
As the risk-free rate rises, a larger discount is applied to future cash flows, making them less valuable in today’s terms. This can lead to lower stock valuations for companies that rely on estimates of future cash flow to derive their value.
The Impact of Higher Rates Can be Sector Specific
Typically, the stock market declines immediately following rate hikes. For example, the S&P 500 declined an average of 4% in the month following an initial increase in the Fed funds rate in data dating back to 1994. However, all sectors are not affected equally by changes in interest rates.
Some sectors, like automotives, and luxury items typically see a decrease in demand for their products when interest rates rise. This could translate to lower sales, and lower stock prices. Since 1994, the consumer discretionary sector has declined an average of 5% in the month after an increase in the Fed funds rate and continued those losses a year later with an average decline of 2% over that time period. This sector includes items that are not necessary for daily living but are appealing if a consumer has enough income to purchase them, like luxury goods, appliances, cars, and entertainment.
On the other hand, some sectors, like utilities, healthcare, and food have relatively inelastic demand — meaning that consumers continue spending on these items even if they have less disposable income. For this reason, demand in these sectors is less impacted by rising rates. Consumer staples, a sector that includes items necessary for daily living, like food and clothing, has contracted about 3% on average in the month following an initial rate increase. However, after one year, companies in this sector have recovered the early losses and ended the period with a 0% decline in stock price. When making investing decisions, it is important to remember that companies in these sectors could still face higher debt servicing costs, which can negatively impact their cash flow and stock price.
Some sectors, like bank stocks, can actually see a boost when interest rates rise. This is because their income can increase as they bring in more revenue from lending activity.
Fluctuations in the Stock Market Are Typically Short Lived
While stocks may react negatively to higher interest rates, these effects are often short-lived. Research shows that the S&P 500 has returned an average of 7.7% in the first year the Fed raises rates in data dating back to 1955.
How Do Rising Bond Yields Impact Stock Prices?
Bond yields typically move with interest rates. So, when interest rates are on the rise, bond yields typically rise as well. In 2022, the 3-month Treasury yield has increased from 0.08% to 1.03%. Likewise, the 5- and 10-year Treasuries have increased from 1.37% and 1.63% to 2.80% and 2.78% respectively.
As yields rise, bonds become more attractive as an investment. This can lead some investors to move their money from stocks to bonds. This shift in investor sentiment can reduce the demand for stocks, and drive prices down.
This is particularly impactful for certain stocks, like those that derive their value from their steady dividend payments. Since bonds also provide a steady stream of income, higher bond yields can tempt investors away from dividend stocks to higher paying bonds. When this occurs, those stocks can lose value.
Adjusting Your Portfolio to Account for Rising Rates
As previously stated, higher interest rates can dampen consumer demand, leading to slower economic growth, lower stock prices, and higher bond yields. But it is important to remember that higher rates do not impact all companies or sectors equally.
In the past, stocks have recovered quickly from rising rates. So, investors with a lengthy time horizon may choose to keep their current allocation and trust that the stock market will recover from its current position. On the other hand, investors that trade frequently, or have short-term investing goals, may choose to shift their allocation toward sectors that have responded well to rising rates in the past.
However, the current business climate is unique in many ways. Supply chain difficulties continue to plague businesses. In addition, changing consumer demand and the lingering effects of COVID-19 have impacted companies, stocks, and the economy as a whole. So, it can be difficult to look to historical comparisons for guidance on how to proceed in this market. That’s where an experienced wealth manager can help. An experienced financial professional can help you find opportunities in this market.
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