Written by: Paolo LaPietra, CFP®
With the Federal Reserve projecting three rate hikes in 2022, a recurring question I’ve been receiving is “How will rising interest rates affect my stocks?” It’s an important question to ask, especially with so much negative sentiment towards rising rates for equity investors. We’ve seen volatility so far this quarter, with the Nasdaq down over 10% and the S&P 500 down around -6%, and it seems we are quick to blame rising rates. But should that be the case?
Why is the Fed raising rates?
The first step towards understanding how rising interest rates will affect stocks is recognizing why the Fed is raising rates. This stems back to the COVID shutdown in 2020. With economic growth coming to a standstill due to the stay-at-home orders, the Fed needed to implement a monetary policy to support the economy and markets. This monetary policy was Quantitative Easing, where the Fed increases the money supply and lowers the borrowing rate to make it easier for banks to lend and consumers to borrow. When the Fed lowers the borrowing rate, this also lowers the yield of new bonds being issued. This created historically low bond yields in 2020 and 2021, pushing investors to equity markets, which was a main driver of outperformance for the S&P 500 in those years. The issue with Quantitative Easing is eventually you see an uptick in inflation. The more money the Fed creates, the less valuable existing dollars are. On top of that, the more money in consumers’ pockets leads to an increase in demand for products and goods, which also drives up prices. Below we can see the effects of QE on inflation.
The Fed’s antidote to inflation is a monetary policy called Quantitative Tightening. Quantitative Tightening is just the opposite of Quantitative Easing, so instead of increasing the money supply and lowering the borrowing rate, the Fed is now restricting the money supply and raising the borrowing rate. When the Fed raises rates, eventually bond yields will rise and become an attractive alternative to stocks, which can lead to a sell-off in the equity markets. An effective way of determining if bonds are attractive enough to cause an equity sell-off is by looking at the 10-year US treasury yield. The 10-year treasury is considered the “risk-free rate” because it’s backed by the US government. When the 10-year rises to 3.5%, history shows us that investors find this as an acceptable alternative to stocks, and we begin to see a sell-off in equities. Currently, the 10-year yield sits around 1.9%, suggesting there is still plenty of room for equity growth. The chart below shows strong stock performance for the next year after the first rate hike, with stocks averaging a 7.3% return and bonds only averaging 3.2%.
What happens to stocks in a rising rate environment?
In a rising rate environment, investors become more conscious of company valuations. The most common calculation is the P/E ratio (Price per share/ Earnings per share). Companies get sorted into two categories when calculating valuations: Growth or Value. Growth companies, which are traditionally made up of technology and biopharmaceutical companies, trade at a higher price-to-earnings ratio than value stocks. Typically, growth companies do not have dividends, have slim to no profit margins, but investors are willing to pay a premium in hopes that the company will have above average growth in the future. Growth stocks thrive in a low-interest rate environment, which has been the case over the past 10 years. When there’s no alternative to equities, investors are more willing to pay a premium. As rates begin to rise and the risk-free rate inches closer to 3.5%, bonds become a more attractive alternative, and investors become hesitant on investing in growth companies and more attracted to value companies. Value companies are dividend paying, have a strong balance sheet, and a lower P/E ratio compared to growth. Diversification is always key, but as the market continues to navigate through a rising interest rate cycle, we should still see equities continue to do well with the potential of value outperforming growth.
If you would like to further discuss the rising interest rate environment and its effect on equities, please feel free to contact our team to set up a meeting.
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Bouchey Financial Group is a fee-only, fiduciary, financial advisory firm with locations in Saratoga Springs & Troy, NY.