Analysis-Harsh reality of ‘higher-for-longer’ rates looms over US stocks

Some investors are bracing for further pain as the Federal Reserve’s aggressive attitude raises Treasury yields while slamming stocks.

For the majority of the year, equity investors dismissed an increase in Treasury rates as a byproduct of stronger-than-expected economic growth, despite concerns that yields could weigh on equities if they rose too much.

These fears may have taken on new urgency when the Fed announced last week that it will keep interest rates high for a longer period of time than many investors anticipated.

Analysis-Harsh reality of 'higher-for-longer' rates looms over US stocks
Analysis-Harsh reality of ‘higher-for-longer’ rates looms over US stocks

Following a 1.5% drop on Tuesday, the S&P 500 is now down more than 7% from its July highs, dragged down by steep falls in shares of some of this year’s greatest winners, such as Apple, Amazon.com, and Nvidia. At the same time, 10-year Treasury yields in the United States have reached a 16-year high of 4.55%.

With policymakers expecting rates to remain near current levels until the end of 2024, some investors believe further volatility is on the way. Higher Treasuries rates, which are sensitive to interest rate predictions and perceived as risk-free since they are backed by the US government, compete with stocks for investment while raising the cost of borrowing for firms and families.

The market “is recalibrating what is an appropriate valuation for equities in a 5% interest rate world,” according to Jake Schurmeier, portfolio manager at Harbor Capital Advisors. “Investors are asking, ‘Why do I need to (take) equity risk when I get a greater return than I do just by holding a Treasury bill?'”

Higher interest rates, if history is any guide, are a less appealing environment for equity investors. According to an AQR Capital Management analysis dating back to 1990, when interest rates were above the median level – as they are now – equities returned an average of 5.4% over cash, compared to 11.5% when loan rates were below their median.

“Stock markets are just plain expensive,” said Dan Villalon, principle and global co-head of investment solutions at AQR Capital Management, who predicts interest rates will be higher in the next five to ten years than they were in the previous decade, reducing returns.

According to AQR’s research, trend-following hedge funds outperform when interest rates rise because they have significant cash positions that benefit from higher rates.

According to Keith Lerner, co-chief financial officer at Truist Advisory Services, the equity risk premium, which measures the attractiveness of equities to risk-free government bonds, has been declining for most of 2023 and was last near its lowest levels in about 14 years.

According to Lerner, the current ERP level has historically translated to a 1.3% average 12-month excess return of the S&P 500 above the 10-year Treasury.

Analysis-Harsh reality of 'higher-for-longer' rates looms over US stocks

The 10-year Treasury yield of up to 4.5% “changes the narrative for stocks,” according to Robert Pavlik, senior portfolio manager at Sioux Wealth Administration, who is holding more cash than usual.

“Investors are going to be more concerned that we could enter into an economic downturn as the price of borrowing rises and corporate profits will be squeezed,” he stated.

According to analysts at BofA Global Research, equities – notably, the tech-heavy Nasdaq 100, which has risen 33% in 2023 due in part to optimism about breakthroughs in artificial intelligence – have previously ignored the risk of rising interest rates.

“However, sentiment may be shifting. “The Nasdaq has resumed its inverse relationship with real rates,” the bank’s analysts noted. “If this continues, the risk is that equities have a long way from where they are to price-in rate sensitive again, hence more downside.”

Harbor Capital’s Schurmeier said he’s been boosting his exposure to long-term bonds and value companies in preparation of a period of high rates weighing on growth stocks, as happened in the mid-2000s after the tech bubble burst.

Of course, many investors expect the Fed will lower interest rates as soon as economic growth begins to slow. Investors are pricing in the first rate drop in July 2024, according to futures linked to the Fed’s key policy rate.

“We don’t believe that ‘higher for longer’ will prove to be true,” said Eric Kuby, the chief investment officer at the North Star Investment Management Corp.

Nonetheless, he has been delaying adding to the firm’s holdings of small-cap consumer firms, concerned that there may be more market turbulence ahead as investors digest higher interest rates and other variables, such as rising energy prices.

“Certainly, the combination of the Fed’s jawboning and the spike of oil prices are creating headwind for equities,” he stated.

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