Rates Rise, Stocks Hold 

Adam Phillips, Managing Director, Investments

The 10-year Treasury yield has moved back above 5%, recently reaching its highest level in nearly 20 years. Normally, a move like that might be expected to create problems for stocks. Higher rates increase borrowing costs, make bonds more competitive with equities and can put pressure on stock valuations.

So far, however, stocks have largely taken the move in stride, with the S&P 500 remaining near its all-time high.

One reason may be why interest rates are rising in the first place.

There is an important difference between rates moving higher because inflation is accelerating and the Federal Reserve needs to tighten monetary policy, and rates rising alongside stronger-than-expected economic growth. Right now, the U.S. economy continues to show considerable resilience.

The Atlanta Fed’s GDPNow model currently estimates that the economy is growing at about a 5% annualized rate in the third quarter. While GDPNow is not an official forecast and will change as additional data becomes available, it points to an economy that continues to expand at a healthy pace despite higher interest rates.

That matters for investors because stronger economic growth generally supports corporate earnings. Higher rates may create a headwind for stock valuations, while stronger growth can simultaneously provide a tailwind for corporate profits. So far, those forces appear to be offsetting one another.

Putting 5% in Perspective
For much of the past 15 years, investors became accustomed to extraordinarily low interest rates. Following the financial crisis, and again during the pandemic, rates remained near zero for extended periods.

Against that backdrop, a 5% 10-year Treasury yield can feel unusually high. Historically, however, that level is not unprecedented. The more unusual environment may have been the exceptionally low-rate period investors recently experienced.

That doesn’t mean higher rates are irrelevant. It does mean investors should be careful about assuming that a 5% Treasury yield is automatically incompatible with a healthy economy or stock market.

A Look Beneath the Surface
There is an important caveat. While the S&P 500 remains near its record high, strength beneath the surface has narrowed.

A relatively small group of stocks has been responsible for a disproportionate share of recent market gains. Although the index itself is roughly 1% below its record, about 40% of S&P 500 companies are down 20% or more from their respective highs.

So while the headline index appears to be handling higher rates well, the experience of the average stock looks somewhat different.

What We’re Watching This Week
Two important economic reports could provide more clarity.

The PCE report on Wednesday will offer an updated look at inflation as well as consumer spending, an important driver of economic growth. Friday’s employment report will provide another read on the health of the labor market.

Together, these reports should help answer a key question: Can the economy continue growing at a healthy pace while inflation remains reasonably contained?

If so, higher yields may continue to coexist with a strong economic backdrop. If inflation remains stubborn or begins moving higher again, however, higher yields could increasingly reflect expectations for additional Federal Reserve tightening.

For investors, the takeaway is straightforward: Don’t focus exclusively on the level of interest rates. Pay attention to why they’re moving.

A 5% Treasury yield driven in part by healthy economic growth is very different from a 5% yield driven by an inflation problem that forces the Fed to tighten monetary policy more aggressively.

For now, the economy continues to hold up, corporate earnings remain supportive and stocks are near their highs. With yields rising and market breadth narrowing, this week’s inflation, spending and employment data should offer important clues about whether that balance can continue.

Often quoted in major national media, Adam is a Chartered Financial Analyst (CFA^®), a CERTIFIED FINANCIAL PLANNER™ (CFP^®), and has been included on the Forbes NextGen Best-in-State Wealth Advisors 2019 list. He is a member of the CFA Society of Los Angeles and the CFA Institute. Adam helps establish asset allocation strategy as a member of the EP Wealth Investment Committee, which supports all EP Wealth Advisors and their clients. The Committee’s top-down approach to portfolio construction begins with an outlook on the economy’s likely direction, followed by the implications for different economic sectors and asset classes. This culminates in strategic selection of the individual stocks, bonds, mutual funds or other investments deemed most appropriate for each individual client’s portfolio. 

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Video Transcript: 

Adam Phillips:

Hi, everyone. Well, it’s been pretty hard to ignore the move higher in interest rates recently. The 10-year Treasury yield has moved back above 5% and recently reached its highest level in nearly 20 years. Normally, you might expect a move like that to create problems for the stock market. Higher rates increase borrowing costs, make bonds more competitive with stocks, and generally put pressure on stock valuations.

But so far, stocks have taken the move largely in stride. We’re recording this on Monday morning, and the S&P 500 remains just 1% from its all-time high. And I think that raises an interesting question: Why are yields moving higher, and why doesn’t the stock market seem particularly concerned about it?

I think part of the answer comes down to why interest rates are rising in the first place. There’s a big difference between rates moving higher because inflation is getting out of control and the Fed needs to slam on the brakes, and rates moving higher because the economy is stronger than expected. And right now, the U.S. economy continues to show quite a bit of resilience.

In fact, the Atlanta Fed’s GDPNow model currently estimates that the economy is growing at about a 5% annualized rate in the third quarter. For those who aren’t familiar with GDPNow, it’s essentially the Atlanta Fed’s running estimate of real (or inflation-adjusted) economic growth based on the data we’ve received so far.

Now, it’s not an official forecast, and the estimate of 5% will continue to change as more data come in. But I think the broader point is pretty clear. Despite higher interest rates, the economy continues to grow at a healthy pace. And that matters for the stock market because stronger economic growth generally translates into stronger corporate earnings.

So while higher interest rates create a headwind for stock valuations, stronger economic growth can simultaneously provide a tailwind for corporate profits. And right now, those two forces seem to be offsetting one another. But I think there’s another part of this story that’s worth considering.

For much of the last 15 years, investors became accustomed to extraordinarily low interest rates. Following the financial crisis—and then again during the pandemic—we went through extended periods when interest rates were near zero and Treasury yields were extraordinarily low.

After living in that environment for so long, a 5% Treasury yield can feel extremely high. But a 5% 10-year Treasury yield isn’t unprecedented historically. The unusual period may have been the one we just came through.

That doesn’t mean higher rates are irrelevant to investors. But we should be careful about assuming that a 5% Treasury yield is automatically incompatible with a healthy economy or a healthy stock market. And so far, the stock market seems to agree. There is one caveat, though.

While the S&P 500 remains near its all-time high, the strength underneath the surface isn’t nearly as broad as the headline index might suggest. Market breadth has narrowed again, with a relatively small group of stocks responsible for a disproportionate amount of the market’s recent gains. There are a number of ways to measure market breadth, but here’s one: although the index itself is about 1% off its record, roughly 40% of index constituents are down 20% or more from their respective high. So when we say the stock market is handling higher rates pretty well, it’s worth remembering that the average stock may be telling us something slightly different.

And that brings us to this week. We’ll get two important pieces of economic data: the PCE report and the September employment report. The PCE report on Wednesday will give us an updated look at inflation, but it will also tell us more about consumer spending, which remains an important driver of economic growth. Meanwhile, Friday’s employment report will give us another read on the health of the labor market.

Taken together, those reports should tell us quite a bit about the question we’ve been talking about today. Is the economy continuing to grow at a healthy pace while inflation remains reasonably contained? Or are we starting to see a less favorable combination of persistent inflation and higher interest rates?

Because if the economy remains healthy and inflation is relatively well behaved, that would support the idea that higher yields are occurring alongside a strong economic backdrop. But if inflation remains stubborn—or starts moving higher again—that becomes a different story.

Then higher yields may increasingly reflect expectations that the Fed needs to tighten monetary policy further. So I think the takeaway for investors is fairly simple. Don’t focus exclusively on the level of interest rates. Pay attention to why they’re moving.

A 5% Treasury yield driven in part by healthy economic growth is very different from a 5% Treasury yield driven by an inflation problem that forces the Fed to aggressively tighten monetary policy.

Right now, the economy continues to hold up, corporate earnings remain supportive, and stocks are near their highs. But with yields moving higher and market breadth narrowing, this week’s inflation, consumption, and employment data should give us some important clues about whether that balance can continue.

We’ll be watching all three closely.

Have a great week.

.