Key takeaways
Equity investors appear to be most focused on factors such as the economy and corporate earnings, though Fed interest rate policy is also a consideration.
Stock market gains across the S&P 500 are broadening out beyond technology to include other sectors.
Investor sentiment remains positive, particularly following the Fed’s interest rate cut in September.
As the Federal Reserve (Fed) initiated what are anticipated to be a series of interest rate cuts (reversing an extended period of steady or rising rates), longer-term bond yields moved higher. Interest rate cuts are buoying equity markets, with the S&P 500 on track for its second consecutive year of gains exceeding 20%.
“Mostly positive earnings news and favorable economic data have the biggest equity market impact today,” says Rob Haworth, senior investment strategy director, U.S. Bank Asset Management. “The market continues to climb on those fundamental factors.” Haworth says Fed’s shift to easier monetary policy has shifted investor interest toward large-cap, high-quality stocks. “For the broader market today, the path of Fed rate policy is less of a near-term concern than the economy and earnings.”
Fed interest rate moves tend to be a signal to bond investors, and beginning in 2022, yields on bonds across the board rose as the Fed raised the fed funds target rate from near 0% to a peak of 5.50%. In October 2023, 10-year Treasury yields topped out near 5%. In mid-September 2024, the 10-year Treasury yield dropped to 3.63%, but subsequently moved back above 4%.1
The major question surrounding future Fed rate cuts, according to Haworth, is the timing and scope of the cuts. “Rates are certainly headed lower, but the interest rate the Fed determines to be a “neutral” rate (compared to today’s elevated rates) may have an impact on equity markets.”
“When interest rates first moved higher in 2022, it took its largest toll on stocks with already high valuations,” says Haworth. That included growth-oriented technology stocks that prospered in a low interest rate environment. “Higher rates mean investors are inclined to pay less for a dollar of future earnings in a company because they can earn more competitive current yields in lower volatility investments like cash and bonds,” says Haworth.
“For the broader market today, the path of Fed rate policy is less of a near-term concern than the economy and earnings,” says Rob Haworth, senior investment strategy director for U.S. Bank Asset Management.
“In 2023, as interest rates appeared to be approaching peak levels for this cycle, markets shifted.” As a result, after underperforming small-cap stocks in 2022, large-cap growth stocks far outpaced small stocks in 2023 and in 2024’s first half. In mid-2024, as interest rates fell, smaller stocks started to outperform large-cap growth stocks.2 This chart compares performance of large-cap growth stocks (S&P 500 Growth) and small-cap stocks (Russell 2000 Index).
If the Fed continues to reduce the fed funds target rate, as expected, “Some equity market sectors may respond more to the Fed’s actions,” says Haworth, noting that financial stocks often respond well to Fed interest rate cuts. “Some sectors might require more significant rate cuts to fully benefit from the declining rate environment.”
Although interest rates moderated in recent months, they remain an important consideration for equity investors. “The Fed isn’t headed back to the pre-2022 ‘zero interest rate’ environment,” says Haworth. “Inflation may be settling in at a higher level, in the 2.5% to 3.0% range. If that’s the case, the Fed is likely to settle its current fed funds rate cuts somewhere close to 3.0%.” Haworth believes equities remain well positioned given present interest rate trends.
As you assess your own circumstances, be prepared for potential stock price fluctuations in the near term. Stocks should continue to represent a key component of any diversified portfolio for long-term investors. “In part, this is due to the fact that equity returns can help investors keep pace with inflation,” says Haworth.
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.
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 circumstances, 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.
With inflation retreating and more interest rate cuts likely coming, how should investors position their portfolios to capitalize on potential opportunities, while guarding against risks?
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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