Are Higher Interest Rates The Harbinger of Gloom for Stocks?

Daniel Hawley |

Are higher interest rates the harbinger of gloom for stocks? That is what the market news headlines are wanting everyone to believe. Well, how true is it though? Yes, interest rates have been at historic lows and this fuelled high growth stocks in 2021 to historically high valuations. The Fed's "temporary inflation" outlook proved less transitory and more embedded in the economy and so the time had arrived to deal with this using the two tools at the Fed's disposal: raising interest rates and tapering or reducing its purchase of central bank assets, essentially a reversal of its quantitative easing policies and removing liquidity from the markets.

The markets reaction was immediate and high growth stocks sold off starting in November. The Nasdaq fell from a high of 16,764 in the second half of November 2021 to 13,724 in January, a fall of just over 20% and now sits at about 14,930 today, the last day of January 2022.

"Pending higher interest rates and Fed tapering required a re-valuation of tech stocks" was the communication coming out of every media outlet. In reality, it prompted a move out of yes, highly valued tech stocks into "value" stocks that had been left behind to that point in time. A sound strategic move, one can argue.

However is the narrative that higher interest rates will lead to lower stock prices of all high growth companies, a story that can be backed up by history. The chart below courtesy of Bloomberg, shows the story of interest rate hikes and S&P market performance. In most cases when the Fed has raised interest rates stocks have moved higher.

Another important issue that requires mentioning is that we are still in a historic low interest rate environment. Even if the Fed were to raise rates 3-5 times, which is debatable, we would still be a historic low interest rates.

Corporate earnings season has over 75% of companies to date meeting earnings expectations. Earnings are strong and services are being re-priced across almost every industry. Trillions of dollars remain on the sidelines waiting to be invested as inflation eats away value in bonds or cash. Strong growth stocks with solid earnings are more likely to outperform holdings of cash and bonds. The recent sell off presents value among the strongest blue chip stocks. The stock market is a forward discounting earnings mechanism. When you look at projected earnings of any growth stocks into 2023-2025, their value proposition looks far more reasonable today.

As we have also mentioned in previous articles, we are at a unique time in history where technological advances across multiple sectors such as AI, Super Computing, Robotics, 5G, Blockchain, Genomics, EV, Battery technology and a long list of so many others that are enabling synergies that can accelerate innovation at a scale that has never been seen before, creating opportunities that have never been seen before.

The narrative of "The Sky is Falling" is overdone and does not correlate with a 50+ year historic fact pattern. There are always downside risks. Black swan events such as COVID and corrections in a secular bull market are to be expected.

When markets fall, newspaper and media headlines make money and between the two, they do a good job of seeding fear. Emotions take over and that is when sound thinking and sound advice helps navigate the inevitable market turbulence to make rational decisions. One of the key benefits of modern portfolio theory is the ability to structure a portfolio in way that can optimize (lessen) your risk for  a desired return.

When the Fed raises rates there is little sound historic basis to suggest stocks will fall. In fact the opposite is more typically the case. Markets tend to rise. In our current economic environment the combination of strong earnings, low interest rates irrespective of several rate hikes and the eventual taming of "inflation" (even if this takes longer than expected which is a strong possibility) suggest that markets can - abscent another black swan event - put in a historic average performance in 2022.