Both stock prices and market breadth peaked a month ago. It has been a tough slog since. The broader market has been trailing mega-caps which are holding up nicely. The 10-day advance/decline line drop has been dramatic as well as other breadth measures.
The culprit for the weakness comes down to two words – oil and rates. Until crude oil and yields start to fall, it will be hard for equities to see a meaningful rally from here. Just look at the huge increases in both factors over the last twelve months. No wonder stocks have been weak lately:
Source: Bespoke Investment Group
Tomorrow’s Fed rate announcement is key for investors. A hike would show that Fed Chairman Warsh is serious about taming inflation. If, on the other hand, Warsh shies away from a hike after his vows last month to make high inflation a “thing of the past,” it could suggest he is all talk.
Current monetary conditions are far from restrictive. With both the economy and labor markets showing welcome resilience, getting inflation down should be the top priority for the Fed. We expect a rate hike tomorrow along with many other investors (a rate hike is now priced at 87%).
Bulls say this is a necessary tap on the brakes. Bears say this is the start of a larger rate hiking cycle. Only time will tell. Our thinking is this depends largely on the trajectory of oil prices. A Fed rate hike should bolster stability, quiet the fears of runaway inflation, and allow stocks to get back and focus on what really matters: the AI buildout and the earnings bonanza it continues to precipitate. The more investors focus on that, the better the market will do.
WHY HIGHER INTEREST RATES HURT STOCK PRICES
As we mentioned in the bullet point above, higher interest rates are one of the primary reasons stocks have had a tough go of it lately. And under the surface of the index levels, numerous stocks are undergoing their own corrections – some are down 10-20% in the last few months. Quality stocks are actually underperforming lesser quality ones.
As interest rates continue to rise, stocks will have a hard time resuming their bull market ways. We present four main reasons rising rates may continue to be a headwind for stocks:
- Slowed consumer spending. Higher rates make loans, including mortgages, more expensive for consumers. People buy fewer homes, cars, and large appliances. Lower consumer demand hurts business revenue and profits.
- Higher borrowing costs for businesses. Companies borrow money to fund and grow their businesses. Higher interest rates increase debt payments. This is especially painful for smaller companies that often use short-term floating-rate debt on their balance sheets. Debt payments are now going up in lock step with higher short-term rates. Higher expenses cut into company profits which can lead to lower stock prices. One of the two major catalysts for this phase of the bull market is exploding profit growth (the other is AI adoption). Bears ask how much will higher rates slow profit growth?
- Competition from bonds. Safer assets like bonds and CDs pay higher interest when rates are high. Right now the spread between dividend yields (the S&P 500 now yields under 1%) and bond rates (the 10-year maturity government bond yield is about 5.0%) is the highest it has been since the 1990s. But bulls correctly point out that this spread was even more unattractive through much of the 1990s, but that didn’t stop stocks from rallying the entire decade. However, common sense tells us that new investor money may go into bonds.
- Lower stock valuations. Stock prices depend on future profits. Investors use a “discount rate” (or interest rate) to determine what those future profits are worth today. A higher discount rate means future earnings are worth less today. This may cause stock prices to drop.
In summary, we see the bull market on “pause” as rates continue to climb. Tomorrow’s Fed rate decision is important. A rate hike could give the bond market confidence that the Fed will do what it takes to tame inflation which has now been above-trend for five years. A stable bond market could also help stocks stabilize.