Recent article from US Bank about rising interest rates and the stock market that may be helpful for our members going in to 2023

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I read an article from US Bank about rising interest rates and the stock market that I thought may be helpful for our members going in to 2023.

We may have a new stock profile out just before the New Year. Have a Great and Safe Holiday Season!

US Bank Article

  • A changing interest rate environment contributed to headwinds for the stock market.
  • The Federal Reserve’s policy shift was a major factor in the repricing of risk assets such as stocks.
  • With rates remaining elevated, stocks remain in a challenging environment.

The investment markets experienced a notable shift in 2022, as the economic environment changed due to a significant rise in interest rates and a persistent surge in the inflation rate. While this had a clear impact on fixed-income investments (bond values decline when interest rates rise), stocks were not immune to the effects of the changing environment.

Significant “repricing” occurred in the stock market, and the Standard & Poor’s 500 stock index, a key indicator for U.S. equities, slipped into a bear market, representing a decline of 20% from its peak value, as did other major market indices. The Federal Reserve (Fed) sought to ease the inflation threat through monetary policy moves including dramatic increases in the short-term fed funds rate and reducing its asset holdings in the bond market. The Fed’s moves are designed to slow the rate of economic growth, ideally without pushing the economy into a recession.

Rising interest rates altered the landscape for equity investors who had become accustomed to an extended low interest rate period. What happens when interest rates rise and what does this mean for your stock positions?

The Fed’s previous “easy money” stance

For a two-year period dating back to early 2020, and for much of the decade prior to that, the Fed pursued what is termed an “easy money” policy. This includes maintaining the fed funds rate at low levels and expanding its balance sheet of bond market holdings. As COVID-19 first emerged in February and March of 2020, the Fed lowered its fed funds target rate to near 0% and boosted its holdings of Treasury and mortgage-backed debt securities.

This helped keep interest rates low across the bond market. The environment created favorable conditions for risk assets, particularly given the relatively unattractive returns generated by fixed-income investments due to the low-rate environment. “Supportive monetary policy was critical for risk asset owners, whether it be in domestic equities, real estate or cryptocurrency,” says Eric Freedman, chief investment officer for U.S. Bank. In 2020 and 2021, the S&P 500 gained 18.40% and 28.71% respectively.

The U.S. economy also performed well over most of this period. In 2021, the economy grew by 5.7% as measured by Gross Domestic Product (GDP), its strongest calendar year of growth since 1984.1 That helped the Fed make progress in meeting one of its mandates, achieving “maximum employment” in the economy. While the Fed states that this goal “is not directly measurable and changes over time,” employment trends remain positive today.2

For the better part of the past four decades, inflation and interest rates were relatively low. It’s an environment that tends to favor equity investors. The question going forward is the degree to which circumstances may change.

Surging inflation tips the scale

A sudden surge in the inflation rate prompted a change in the Fed’s monetary stance. In 2021, the cost-of-living as measured by the Consumer Price Index rose 7%. Inflation over the 12-month period ending June 2022 reached 9.1%, the highest increase in annual living costs since 1981.3 This far exceeds the Fed’s goal of maintaining annual inflation in the range of 2% over the long term. While inflation has subsided modestly since, it remains far above the Fed’s target range.

“As the Fed tightens interest rates, we can expect a decline in economic growth.”

– Eric Freedman, chief investment officer for U.S. Bank Wealth Management

Changes in the bond market reflect the Fed’s policy shift. The yield on the 10-year U.S. Treasury note, a benchmark of the broader bond market, rose from 1.52% at the end of 2021 to more than 4% in October 2022, its highest level in more than a decade.4 Yields on the 3-month U.S. Treasury bill (more closely related to the fed funds rate) jumped from 0.06% at the end of 2021 to 4.45% by late November 2022.

Higher rates alter the equity investment landscape

There are various reasons why increasing interest rates can have an impact on equity markets. One is that it could affect future earnings growth for U.S. companies. “As the Fed tightens interest rates, we can expect a decline in economic growth,” says Freedman. In fact, GDP growth slowed in the first half of 2022, even declining by an annualized rate of 1.6% in the first quarter of the year and 0.6% in the second quarter. The economy rebounded modestly in the third quarter, with an annualized growth rate of 2.9%.1

Another reason stocks may underperform as interest rates rise is that bonds, certificates of deposit and other vehicles pay more attractive yields. “If interest rates move higher, stock investors become more reluctant to bid up stock prices because the value of future earnings looks less attractive versus bonds that pay more competitive yields today,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Present value calculations of future earnings for stocks are tied to assumptions about interest rates or inflation. If investors anticipate higher rates in the future, it reduces the present value of future earnings for stocks. When this occurs, stock prices tend to face more pressure.

“The hardest hit stocks have primarily been those with premium price-to-earnings (P/E) multiples,” continues Haworth. In other words, stocks that are considered “pricey” from a valuation perspective suffered the largest price declines. This included secular growth and technology companies that enjoyed extremely strong performance since the pandemic began. Haworth notes that prior to the Fed’s policy shift, several stocks that generated little to no current earnings saw their stock prices inflated as investors focused on the potential for future earnings. “Markets are less likely to ‘pay up’ for stocks that are unable to generate meaningful current earnings if interest rates continue to move higher,” says Haworth.

An additional factor that creates challenges for equity markets, according to Haworth, is that higher debt costs (resulting from elevated interest rates) can cut into corporate profit margins. “Companies that have to roll over debt in today’s market must pay more for that debt.” That opens the door to the potential for reduced corporate earnings going forward, Haworth says. Lower earnings are typically reflected in lower stock prices.

A less predictable environment

One of the biggest questions is the degree to which the Fed will have to tighten its monetary policy to slow inflation. Changes in the inflation rate have declined since mid-2022, but they continue to exceed the Fed’s comfort level. “It’s clear that the Fed policy shift created great change in the markets,” says Bill Merz, senior portfolio strategist at U.S. Bank Wealth Management. “The potential for continued volatility in capital markets remains high and the range of possible outcomes is wide.” Merz notes that the Fed faces a difficult balancing act, trying to temper growth sufficiently to tamp down the inflation threat without causing a recession.

It should be noted that a changing interest rate environment, while creating more headwinds for stocks, doesn’t mean there isn’t continued upside opportunity. “The key is how well companies perform,” says Haworth. “A major question is whether earnings expectations are downgraded. Most companies have been hesitant to provide guidance on future earnings, reflecting this uncertain environment.” One key earnings variable is whether the economy avoids a recession. A struggling economy would likely detract from corporate earnings and create more risks for the equity market.

There are reasons to be prepared for the prospect of additional asset repricing similar to what propelled stocks into bear market territory in the first half of the year. A key variable likely to weigh on the markets is how aggressively the Fed continues to raise interest rates. The equity market tends to rebound when investors anticipate fewer Fed rate hikes going forward, but that sentiment often changes depending on the most recent economic data release. Markets have reacted in a volatile way as positive and negative economic news emerges.

Putting your portfolio into perspective

As you assess your own circumstances, it may be wise to maintain limit expectations for equity market performance in the near term. Nevertheless, assuming the Fed succeeds in tempering inflation and the economy recovers, stocks remain well positioned over the long term. At the same time, it’s important to be prepared for the potential of ongoing market fluctuations.

Talk with your wealth professional about your current comfort level with your portfolio’s mix of investments and discuss whether any changes are appropriate in response to an evolving capital market environment.
Source: USBANK

As mentioned above we see 2023 as a transformational year for our group. There are some very exciting things coming and you will see the changes going forward.

This year has been interesting for the markets to say the least, so here is a little humor for you.  “Santa’s Solar Sleigh” 

The Traders News Team

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