Rates higher for longer? Implications for equity investing

Investor sentiment has shifted from one of optimism for Fed driven rate cuts in 2024 to one of a delay for rate cuts to as late as early 2025.  While this is based on recent economic data showing a resilient economy to already elevated rates, a “higher altitude” view of the economy is reflecting a slowing of economic activity.  Thus, the question that is raised is, “if rates stay higher for longer, does this lead to equity markets being lower for longer?”

It is important to note that while recent pullbacks in equity prices have certainly reflected investor fears of higher rates, geopolitical turmoil has also played a role.  The concerns related to an expanding and protracted Israeli war with Hamas and others such as Iran certainly were evidenced by recent volatility in the equity markets. These concerns seem to have abated – the fear gauge is dropping.   The assumption that the Fed will likely need to delay what was communicated as a timeline for rate cuts during 2024, based on recent data remains the primary influencer of market volatility.    

The concern over higher rates for longer is really the key driver of anticipated equity investment volatility over the coming months.  “Bad news has been good news” for many equity sectors when looking at weakening economic data leading to assumptions of more aggressive rate cuts, and therefore lower rates leading ultimately to positive impact on corporate earnings.   

Do historically higher rates mean historically lower returns?

It is important to look at history though to determine if in fact, periods of historically higher rates lead to periods of historically lower equity returns.  According to data from BMO Capital Markets looking back to 1990, during periods of higher bond yields, the S&P posted an average price return of 13.9% compared to an average gain of 6% during periods of rates dropping.  While this one comparison is important for context, underlying this is the conclusion that earnings were such that they did not disappoint investors during such period, and in fact the higher rate environment most likely reflected an underlying robust economy.

Is the equity investor’s focus undertaking a “pivot” from rates to earnings?

A critical question to pose at this time is, “with the uncertainty of timing of Fed rate cuts being actually less certain, since a delay is the last step before cuts, do the equity markets pivot from rate focused to earnings focused?” Given the latest perspective of the Fed “needing” to be patient and not rush to cut rates so as to avoid “reigniting” inflation, this may finally end the anticipation and obsession on rate cuts and lead back to more a fundamental view by equity investors that is focused on earnings and forward-looking realistic guidance.

What is the appropriate strategy for equity portfolio investment in the coming months?

When looking at the economy from a macro perspective, U.S. economic data is showing that the rate 

of increase in activity in manufacturing and service sectors is slowing. This would support the view 

that while the Fed may wait till the fourth quarter of 2023 or early 2024 before beginning to cut 

rates, the likelihood of rate hikes is, while not impossible, remote at best.  The stronger than 

expected growth trends are positive for the economy and corporate profits in the immediate term, 

however, an underlying economy that while strong is moderating will likely create volatility in price 

movement of individual issues.  Multiples, considered by many to be elevated by historic standards, 

and corporate earnings, either announced or projected, must meet or exceed what these multiples 

imply.

 

For example, according to “Bloomberg Intelligence,” the “Magnificent Seven” largest US stocks’ 

profit lead is set to shrink in 2024.  In particular, the forecast for the Seven’s year over year net 

income growth has declined to roughly 20% which is far closer to the 10-15% that the S&P 500 is 

being forecast.   In the fourth quarter of last year, the Seven had growth expectations of closer to 

50% plus year over year compared to last for the S&P 500.

 

What this means is that not only do companies need to meet and beat consensus estimates for 

earnings but also provide believable guidance as to how they will meet the 2024/25 operating 

environment – reflected in earnings forecasts that satisfy equity investors.  The unknown is, “will 

profit growth from a stronger than expected economy improve and more than offset the concerns

of higher than expected interest rate levels, or will the higher rates and the negative impact they 

may bring on the economy ultimately wipe out the shorter-term lift to earnings and overall depress 

earnings?”

Equity Index Performance: Year-to-Date

Source: Bloomberg

Given this possible transition of equity investor focus, what is the strategy for equity investing?

When looking to build and confirm equity portfolio strategy during this potentially volatile period of the months ahead, community bank equity portfolios should continue to incorporate several broader based, balance sheet level perspectives.

First, understanding and being comfortable with the longer-term investment horizon for investment grade total return driven equity selection is important to “see beyond” what might be a period of changing earnings forecasts and resulting elevated price volatility.  Comfort levels are achieved and maintained by clarity around how changing equity values affect certain metrics, such as month-to-month income, since the change in value of equities flows through to the income statement and related performance measures.  Shorter-term volatility in stocks can create shorter-term volatility in earnings and certain capital calculations.  A “range of acceptability” for volatility allows ongoing equity investment strategy during such periods.

Second, a realistic and relevant period for measuring performance is critical for equity investment strategy during potentially volatile periods.  Performance is measured through not just the return as driven by dividend and appreciation but also relative to the cost of funding the equity.  Currently, the cost of funding equity purchases is at 5% or higher, on the margin.  A perspective of longer-term accretive spread looking out over 3-5 years is an important assumption that must be held, and underlying this, is the view that cost of funding will drop based on historic yield curve trends long-term and likely Fed action shorter-term.

Finally, understanding the long-term nature of the equity portfolio and its fit into the institution’s particular business model drives both sizing and timing of equity portfolio activity.  Alternative uses of funding, additional alternative sources of income, and alternative longer-term contributors to capital all help prioritize equity investment strategy, within the overall balance sheet management perspective.