Brad on the Markets
Updated: Sep 13, 2022
Rate Hikes and the Markets
As you are probably aware, the Federal Reserve has hiked the Fed Funds rate .75% in both June and July of this year and have signaled that they are not done. Currently we sit at a rate of 2.25%-2.5%. Could we see 3.5%-4%? Maybe. Remember where we were just a year ago? It was .08%! It had been down here since 2009 (Federal Funds Effective Rate (FEDFUNDS) | FRED | St. Louis Fed (stlouisfed.org). As a result, for fixed income investors, they were only able to get .0 something% return on their money market accounts, CD’s, or treasury bonds. As I look today, I can find 6 month T Bills yielding 3.2% and the 1 year yields at 3.353%. This move in yields is nothing short of dramatic. In fact, it is one of the fastest moves upward since the early 1980’s.
We should keep this in perspective. I know several older investors that love to remind me of the 80’s when the rate was 22.36% in 1981. Whenever I hear them give me this comeback, I always ask them what the unemployment rate was at the time. Do you remember? It was over 7.5% and peaked at over 10% by 1982. Contrast that to today’s unemployment rate of 3.5% (Unemployment Rate (UNRATE) | FRED | St. Louis Fed (stlouisfed.org). So, a major difference in the economy was that when we were having such phenomenally high rates, we also had high unemployment. With so many people currently working, we are seeing inflation of wages (finally). This wage inflation can be a double edged sword. On one hand it can help consumers offset much of the price inflation. On the other hand, it can have the effect of reducing profit margins for corporations thus reducing the overall profitability of these companies. Inflation is running hot. The total increase in inflation over the course of one year has been 58.88% but it does appear to be slowing. The S&P GSCI Index (commodity index) is now down 19.8% from the highs set at the beginning of summer (Commodities Indices, S&P GSCI Chart, Prices - Barchart.com).
How do rates affect the stock market
As rates have moved higher we are seeing a re-pricing of various risk assets like stocks. For the last couple of years, the Fed has been keeping rates low which we often refer to as an easy money policy. As rates were very low, risk assets like stocks were very appealing to investors and these investors were rewarded with S&P 500 returns of 18.4% in 2020 and 28.71% in 2021. Alongside the S&P 500, the overall economy also grew by nearly 6% in 2021 (as measured by GDP) which was the highest rate of growth by our economy since 1984 (US Bureau of Economics). With the sudden surge in inflation as discussed above, the Fed has had to pivot to raising rates.
There are several reasons why rising rates have historically been negative for stock investors. First is that rising rates slow the country’s economic growth. If the economic growth of the entire country slows it makes sense that this would also slow the earnings potential of companies that are located here or sell their wares domestically. So, if this were to happen then supposedly, we should see the earnings growth of these companies slow as well. In my opinion, what we are seeing is simply a repricing of stocks to factor in this slowdown in potential earnings. This may be why the biggest drops have come to those companies that trade at a premium to their growth rate or PE multiples. Stocks that are expensive have gotten hurt more than stocks that trade at a more reasonable multiple. Another reason why stocks may be selling off is that now with rates on fixed income instruments being higher than they have been in years, many investors are saying to themselves “Why should I take on the added risk of stocks when I can now get 3% on US Treasury bonds?” When rates were close to zero, people had to move to riskier assets as there was really no choice in fixed income. Now that people have a choice, investors who are more conservative in nature or closer to retirement goals, may choose to invest more money in fixed US Government backed securities.
Read: Stock Market Correction Time?