Key takeaways
The impact of higher interest rates on the stock market has changed since early 2023.
When rates were moving higher, it took a toll on stocks with higher valuations.
As rates approached peak levels, the impact was more significant on companies forced to issue debt at higher rates.
While rising interest rates initially took a toll on the broader stock market (the S&P 500 lost more than 18% in 2022), stocks rallied significantly in 2023, with the S&P 500 gaining more than 26%.
The stock market’s recovery should not be considered an indicator that today’s higher interest rates no longer have an impact on equity market performance. In fact, beginning in 2023, the impact began to shift course, as the higher cost of debt became a factor for companies that faced higher borrowing costs.
With the anticipation of lower interest rates, markets rallied broadly across the board in the closing months of 2023. But signs in early 2024 that interest rate cuts may not be coming as quickly as some had expected has again narrowed equity market leadership. S&P 500 performance in the opening weeks of 2024 is dominated by the same narrow band of tech-oriented stocks that outperformed the broader market in 2023. This segment of the market represents companies that may not be highly dependent on issuing debt and incurring higher interest costs.1
What direction are interest rates likely to move from here and what impact could it have on stocks?
Interest rate trends track with inflation data
The rising interest rate trend that began in 2022 occurred after the re-emergence of inflation. The cost of living, as measured by the Consumer Price Index (CPI), surged to a peak of 9.1% for the 12 months ending June 2022. In a move designed to help control inflation, the Federal Reserve (Fed) began raising the short-term federal funds target rate, in March 2022. From that point through July 2023, the Fed bumped rates higher eleven times, from near zero percent to a range of 5.25% to 5.50%. Interest rates across the broader bond market rose as well during this period, making borrowing more expensive for consumers and businesses. This was intended to slow economic growth and employment as a way to temper the inflation threat. In January 2024, inflation over the previous 12 months stood at 3.1%, much lower than its peak, but not yet down to the Fed’s 2% target.2
“When interest rates first started moving higher in 2022, it took its largest toll on stocks with already high valuations,” says Rob Haworth, senior investment strategy director at U.S. Bank. That included growth-oriented technology stocks that prospered in a low interest rate environment. “In 2023, as interest rates appeared to be approaching peak levels for this cycle, the impact shifted,” says Haworth. “The focus now is on how interest rates impact company finances, and that’s hurting a different segment of the stock market, namely smaller stocks.”
Notably, says Haworth, smaller companies are more dependent on debt issuance than many of the large, profitable growth companies that suffered setbacks when rates initially shifted higher. “For many smaller companies, the cost of funding at higher interest rates will become a challenge more quickly than is the case for many larger companies, which often issue longer-term debt,” says Haworth. “Higher borrowing costs can cut into a company’s earnings.” Markets appeared to recognize this fact. As a result, after underperforming small-cap stocks in 2022, large-cap growth stocks far outpaced small stocks in 2023 and have started 2024 in the same, advantageous position. This chart compares performance of large-cap growth stocks (S&P 500 Growth) and small-cap stocks (Russell 2000 Index).
U.S. economy boosts stocks
While interest rate trends can have a bearing on the stock market, performance is also closely tied to the strength of the U.S. economy. “As the Fed raises interest rates, we typically expect slower economic growth,” says Eric Freedman, chief investment officer, U.S. Bank Wealth Management. Surprisingly, however, Gross Domestic Product (GDP) grew more quickly in 2023 (2.5%) than it did in 2022 (1.9%).3 The economy’s continued growth in the face of higher interest rates was due in large part to strong consumer spending, fueled by above-average wage growth.
Haworth notes that modest corporate earnings growth occurred in 2023’s final two quarters. “If we assume interest rates are near a peak for the current cycle, economic trends and specific company considerations are likely to have a greater bearing on stock performance going forward.” Haworth says investors are likely to put more emphasis on factors such as how fast companies can grow and whether they are experiencing sufficient earnings growth.
Yet interest rates are still a consideration for equity investors. Stock prices tended to track with bond yield trends over the course of 2023. When interest rates rose, stock prices retreated, and when rates fell, stocks reacted favorably. Haworth still anticipates a continuation of the kind of market volatility that’s existed since mid-2023. “The market is waiting for more news in terms of the timing and extent of Fed rate cuts in 2024.”
A cloudy outlook
The market remains heavily focused on the Fed’s next decisions about interest rates. It held the line on rates after its last rate hike in July 2023. After its January 2024 meeting, Fed chair Jerome Powell indicated that Fed rate cuts were likely in 2024,4 but the timing of such cuts remains a question mark. “The Fed is very focused on achieving its long-term inflation target of 2% (still below the current rate of 3.1%),” says Freedman.
While interest rates may fluctuate up-and-down in the near term, with some ramifications for stocks, it isn’t the only factor equity investors should consider. “One of the variables we’re watching is whether the declining inflation rate results in stock valuations appearing more reasonable,” says Haworth. He notes that if inflation declines from current levels, it would generally benefit stock valuations.
Nevertheless, stocks may still be subject to near-term volatility. “To bid stock prices higher, investors need to believe that earnings will grow faster than is indicated by current expectations and generate more attractive growth potential than the current elevated yields on fixed income instruments,” says Haworth.
Putting your portfolio into perspective
As you assess your own circ*mstances, be prepared for potential stock price fluctuations in the near term. Nevertheless, assuming that current inflation trends endure, and the economy can hold its ground, stocks should continue to represent a key component of any diversified portfolio for long-term investors.
Talk with your wealth professional about your comfort level with your portfolio’s current mix of investments and discuss whether any changes are appropriate in response to an evolving capital market environment consistent with your goals, risk appetite and time horizon.
Note: The Standard & Poor’s 500 Index (S&P 500) consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The S&P 500 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. The Russell 2000 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.
Frequently asked questions
Interest rates can affect stock markets in different ways. Frequently, when rates rise, equities are challenged because investors can choose to invest in bonds that pay more attractive yields than was previously the case, rather than stocks. Higher rates can put pressure on stock valuations, as corporations may need to generate more attractive earnings to capture investor interest. Another way the interest rate environment affects stocks has to do with companies’ bottom lines. If a debt-issuing company faces higher borrowing costs due to rising rates, it may result in reduced company profits, which can be reflected in lower stock prices. These factors are among the reasons why equity investors pay close attention to the interest rate environment.
If the Federal Reserve raises the short-term federal funds target rate it controls (as it did in 2022 and 2023), it can have a detrimental effect on stocks. A higher interest rate environment can present challenges for the economy, which may slow business activity. This could potentially result in lower revenues and earnings for a corporation, which could be reflected in a lower stock price.
There is not a direct correlation on the direction of interest rates stemming from stock market movement. The state of the economy and inflation are bigger factors that help determine the direction of interest rates. In many circ*mstances, interest rate movements can affect stock prices. The biggest impact stock prices have on interest rates is on the demand for bonds. If stock prices decline, it may indicate investors are seeking to reduce portfolio risk and putting more money to work in bonds. This reflects an increase in demand for bonds, which typically allows issuers to offer debt at lower interest rates.
