Implications of higher for longer on the stock market
The anticipation of significant interest rate cuts by the Federal Reserve has been a driving force behind the repeated record-breaking performance of stocks. With the diminishing case for rate cuts, there is a growing focus on analyzing the bull market.
The S&P 500 has experienced a 7.4% increase this year and is currently only 2.5% below its all-time high, which was set on March 28. Stocks have continued to rise after 10-year government-bond yields reached their highest point in late October. This also contributed to a widespread surge in prices for various asset classes, including gold and bonds.
However, there is growing concern among investors that future gains in the stock market could be harder to achieve. Wednesday’s inflation report, which came in hotter than expected, has sparked concerns about the Federal Reserve’s ability to implement interest rate cuts this year in the absence of any indications of an economic slowdown. Earlier this year, financial analysts predicted a series of interest-rate cuts extending into 2024. However, there is now growing skepticism among investors regarding the likelihood of any rate reductions by the Fed.
That could potentially have negative implications for the stock market. The yield on the benchmark 10-year Treasury note concluded the week at 4.499%, following its largest single-day increase since 2022 on Wednesday.
When yields rise, stocks become less appealing compared to holding Treasurys until they mature. Additionally, borrowing costs across various sectors of the economy, such as corporate debt, mortgages, and car loans, also go up.
According to Quincy Krosby, the chief global strategist for LPL Financial, the math is altered. You need to make adjustments and ensure that the rate regime aligns with the current valuations.
These are a few sectors of the stock market that could be impacted by increased interest rates:
Last week, the S&P 600 index, which primarily focuses on small-cap stocks, experienced a significant decline of 3%. There was a 2.9% decrease on Wednesday following the release of the inflation report, marking the biggest single-day drop since February. Small-cap stocks, which primarily generate revenue domestically, are particularly influenced by the direction of the economy.
One major factor: Smaller stocks typically allocate a significantly higher portion of their operating profit towards servicing debt interest compared to larger stocks. According to Dow Jones Market Data, the operating income to interest expense ratio within the S&P 600 was 2.3 times as of March. In contrast, S&P 500 companies have a multiple of 7.6.
Smaller companies tend to issue a higher proportion of floating-rate debt compared to larger companies, resulting in loan payments that vary in response to benchmark interest rates. When rates increase, it implies elevated interest expenses that impact their financial performance and increase the likelihood of defaults.
According to data from Lazard Asset Management, at the end of last year, about 44% of debt among companies within the Russell 2000, another small-cap index, was floating-rate, while the S&P 500 had only 10% of its debt in this category.
Further exacerbating the situation: Approximately 40% of the companies in the Russell 2000 failed to generate any profits in the previous year, in stark contrast to the 10% figure observed in the S&P 500, as reported by J.P. Morgan Asset Management.
Artificial-intelligence technology has fueled a surge in investor enthusiasm, leading tech stocks to dominate the market’s advance since early 2023. Large companies possess robust balance sheets and substantial cash reserves, which should provide them with protection against the impact of increased interest rates. However, there are concerns among investors that their growing popularity might become a disadvantage if market sentiment turns negative.
The information-technology sector of the S&P 500 holds a significant share of almost 30% in the market-value weighted index, which is more than double the size of any other sector among the 10. If investors opt to cash in on their gains, tech stocks are a logical choice to consider.
When examining the various actively managed mutual funds and cap-weighted index funds available, it becomes apparent that they all offer similar options. Which company has the largest holding: Microsoft or Nvidia? Is it Amazon? According to Emerson Ham III, a senior partner at Sound View Wealth Advisors. If there were to be a downturn in the market, it is possible that large tech stocks may face some challenges.During the period when the Fed initiated its interest-rate-increase campaign in 2022, the tech sector experienced a significant decline of 30% by the end of the year. Similarly, the consumer-discretionary sector, which includes prominent companies like Amazon.com and Tesla, also faced a substantial decline of nearly 40%.
When interest rates rise, stocks that are tied to the economy’s performance, like utilities, consumer staples, and industrials, become less attractive. This is mainly because they are often considered as dividend-focused investments.
The dividend yield of the utility sector in the S&P 500 is 3.4%, while consumer staples pays 2.4% and industrials has a yield of 1.4%. Those all appear insignificant when compared to the 4.5% risk-free rate on government bonds. In addition, the stocks are not providing sufficient additional yield to offset the potential risk of a decline in business activity due to higher interest rates.
3M, an industrial conglomerate, currently has a dividend yield of 6.6% and its shares have experienced a slight decline of 0.1% this year. On the other hand, Walgreens Boots Alliance, a consumer-staples company, offers a yield of 5.6%, but its shares have seen a significant decrease of about 30%. Lastly, American Electric Power provides a dividend yield of 4.3% and its shares have shown a modest increase of 1.1%. All three are not meeting the performance of the S&P 500.
Approximately 40 stocks in the S&P 500 currently have a dividend yield that surpasses that of the 10-year Treasury note, as reported by FactSet. Two years ago, at the beginning of the Fed’s interest-rate campaign, there were 94 stocks that had a higher yield.
When interest rates rise, depositors tend to shift their money towards Treasurys and money-market funds in search of better returns. This, in turn, leads to a decrease in deposits at banks. Meanwhile, banks have been forced to pay higher interest rates to attract depositors seeking higher returns, which has had a significant impact on the profitability of smaller and medium-sized banks. Wells Fargo announced on Friday that it anticipates a decrease of 7% to 9% in net interest income, which is the profit generated from lending, by 2024.
If interest rates remain high, there is a possibility that delinquency rates could rise as well. This, in turn, may lead to increased loan losses for banks.
Mortgage rates have risen to around 7%, a level not seen since December, due to the impact of higher interest rates. This has caused numerous potential home buyers to hesitate, resulting in significant decreases in mortgage activity at major banks, which impacts their revenue.
The real-estate sector of the S&P 500 has experienced a decline of 7.2% this year, making it the poorest performing segment among the 11 groups and the only one to be in negative territory.
Smaller banks have been disproportionately affected by the rate whipsaw compared to larger ones. The KBW Nasdaq Bank Index, which includes major players like JPMorgan, has seen a 2.1% increase in value so far this year. On the other hand, an index of regional banking stocks has experienced a decline of 13%.
Shares of oil-and-gas companies are once again gaining momentum after a strong performance in 2022. Oil prices on the rise are proving to be a boon for oil-and-gas providers, with major companies in the sector trading at a lower value compared to the overall market. Exxon and Chevron have a price-to-earnings ratio of approximately 13 and 12, respectively, based on their earnings over the past 12 months. In comparison, the S&P 500 has a price-to-earnings ratio of around 20.
Over the past month, the S&P 500 energy sector has outperformed every other sector in the broad index by at least 3 percentage points, with an impressive gain of almost 10%.
