US WEEKLY KICKSTART

• Our recent conversations with both corporate executives and portfolio managers have focused on the impact of higher rates on equities. The 30-year US Treasury yield has climbed to 5.3%, the highest level in nearly 20 years. Our economists expect the Fed to hike the funds rate by 25 bp next week.
• Rising interest rates are a headwind for equity valuations, but earnings are the most important driver of stocks. The S&P 500 forward P/E has declined from 22x at the start of the year to 19x today, but the index nonetheless sits within 2% of its record high.
• While the S&P 500 P/E multiple has declined this year, valuations relative to bonds have been roughly unchanged. The equity risk premium is currently 3% and has been fairly stable during the last two years. Regardless of the level of rates, elevated interest rate volatility also creates a challenge for stocks.
• Equities typically struggle when the Fed starts to hike rates, but we expect the bull market to continue. The S&P 500 has generated an average 3-month return of -2% at the start of seven hiking cycles during the last few decades, and Fed tightening is one of the dynamics that has characterized the end of other major bull markets during the past century. However, equities have often performed well during tightening cycles. The S&P 500 has generated an average return of +9% during the 12 months following the first hike. Today, the market is already pricing more than three hikes within the next year, and corporate earnings and balance sheets are both robust.
• Higher interest rates have varying effects on stocks via valuations, balance sheets, and earnings. For investors, stocks involved in home construction are one of the most sensitive parts of the equity market to long-term interest rates. The stocks have underperformed the equal-weight S&P 500 by 16 pp since June. In contrast, Financials typically outperform as rates rise.
• A company can maintain its valuation in the face of rising interest rates if its risk premium falls or its growth rate rises. To fully offset the impact of a 1 pp increase in the cost of equity from today’s levels, a company’s expected long-term growth would need to increase by 2 pp. One way to boost growth is through investment in capex and R&D. M&A and spinoffs are other avenues for companies to improve their growth trajectories.
• We rebalance our Long Duration (GSTHLDUR) and Short Duration (GSTHSDUR) baskets in this report. See Exhibit 16 and Exhibit 17 for the constituents of the baskets.

What higher interest rates mean for US stocks

The 10-year US Treasury yield surged to nearly 5% this week, reaching its highest level since October 2023. Following an above-consensus CPI print, our economists expect a 25 bp hike at the FOMC meeting next week. Our rates strategists believe that the combination of rising oil prices, a repricing of the Fed path, strong economic growth, and AI investment have lifted long-term interest rates.

Our recent conversations with both corporate executives and portfolio managers have focused on the impact of higher rates on equities. Below we highlight 7 key points and 14 charts.

1. Equity multiples have declined this year but valuations relative to bonds have been roughly unchanged. The S&P 500 forward P/E has declined from 22x at the start of the year to 19x today. While there have been multiple contributors to the declining P/E, including AI-related uncertainty and skepticism about the durability of recent earnings strength, one contributor is the rise in interest rates. The difference between the S&P 500 earnings yield (5.2%) and the real 10-year US Treasury yields (2.6%), a simple proxy for the equity risk premium, is currently 270 bp. Outside of brief market downturns, this “yield gap” has been fairly constant during the last two years, as has the equity risk premium implied by our S&P 500 dividend discount model.

2. Equities typically struggle at the start of Fed hiking cycles, but the market has already priced substantial Fed tightening in coming months. The S&P 500 has generated an average 3-month return of -2% at the start of seven hiking cycles during the last few decades. However, the S&P 500 then generated an average 12-month return of +9%, with positive returns in every episode but 2022. In 1997, for example, the S&P 500 declined by 10% alongside the Fed’s 25 bp hiking “cycle.” Stocks bottomed when the market ceased pricing additional tightening, and the S&P 500 reached new highs within three months. Today, the rates market is already pricing more than three 25 bp hikes by the middle of 2027, lifting the bar for policy to surprise in a hawkish direction. The medium-term impact of Fed tightening on equities will depend on how tightening affects earnings growth, which is the most important driver of stocks.

Within the equity market, sector performance has been inconsistent at the start of past Fed hiking cycles. Energy and Tech have delivered the strongest returns on average during the 3 months following the first Fed hike, while Health Care has posted the weakest average returns. However, no sector has delivered consistent out- or under-performance across past hiking episodes.

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3. Equities are usually more sensitive to long-term interest rates than short-term rates. One way to frame the value of an equity is as a discounted stream of long-term future cash flows. Our dividend discount model shows that roughly 75% of the present value of the S&P 500 reflects cash flows 10+ years in the future. Mirroring the long-term nature of equity cash flows, the correlation of S&P 500 returns with changes in interest rates is strongest for long-term bonds. Because inflation boosts the nominal values of future cash flows, equity valuations are more vulnerable to rising real rates than to nominal rates.

4. In addition to the level of bond yields, interest rate volatility matters for equities. Stocks typically struggle to digest sharp increases in bond yields. During the past few decades, stocks have usually generated positive returns alongside rising interest rates unless the pace of rising rates exceeded 2+ standard deviations. Today, a 2 standard deviation move in 10-year Treasury yields would equate to about 50 bp over a month or 30 bp over two weeks. The speed of the rate moves during the last few weeks helps explain why stocks struggled to digest those changes.

5. Corporate balance sheets today face limited fundamental risk from rising interest rates. Interest rates can affect corporate earnings and solvency in addition to equity valuations, but those risks appear limited today. S&P 500 borrow costs have increased modestly during the last few years alongside higher bond yields. However, the increase has been modest because most S&P 500 company debt carries fixed rates and long maturities. In addition, interest expenses remain small relative to strong profits. Interest coverage ratios for the aggregate S&P 500 and its median stock rank in the 99th and 68th percentiles relative to the past 20 years. Smaller companies generally have weaker balance sheets and higher shares of floating rate debt, making them more vulnerable.

6. The sensitivity of equities to interest rates varies widely across the market. The valuations of “long-duration” stocks with high growth rates and low current profits are particularly vulnerable to rising yields because the cash flows underpinning their present values are concentrated in the distant future. In contrast, Financials earnings and share prices tend to benefit when interest rates rise. Like the broad Info Tech sector, AI stocks have exhibited a modest negative correlation with real yields.

For investors, stocks involved in home construction are one of the most direct ways to express a view on long-term interest rates within the equity market. The sensitivity of homebuilders to interest rates has been relatively stable over the past few years, and the stocks have been relatively insensitive to the broad macroeconomic growth outlook. Housing stocks have traded in lockstep with bond yields during the past few months, underperforming the equal-weighted S&P 500 by 16 pp since June.

7. A company can maintain its valuation in the face of rising interest rates if its risk premium falls or its growth rate rises. Interest rates rarely move in isolation, and shifting rates are usually accompanied by changes in equity risk premium. For the broad market, the ERP depends on factors including the economic growth backdrop, investor demographics and risk appetite, and monetary policy. For a given stock, the ERP also reflects company-specific risk.

While changing the perceived risk profile of a company is possible, corporate managements can more directly alter the growth trajectories of their businesses. To fully offset the impact of a 1 pp increase in the cost of equity from today’s levels, a company’s expected long-term growth would need to increase by 2 pp.

The incentive to spur growth in the face of rising interest rates is one of many factors supporting the ongoing boom in AI investment. One way to boost growth is through investments in capex and R&D. This past earnings season, roughly half of S&P 500 companies discussed adopting AI in their businesses to boost productivity. Other companies will use AI to generate new streams of revenue.

The ongoing acceleration in M&A activity highlights another avenue for companies to improve growth. US announced M&A volumes have totaled $1.4 trillion YTD, with global volumes up 36% year/year. Spin-off activity has been relatively muted during the last few years, but pressure from interest rates may drive additional companies to “shrink to grow” by spinning off low-growth or non-core businesses.

We rebalance our Long Duration (GSTHLDUR) and Short Duration (GSTHSDUR) baskets in this report. We estimate the weighted average distribution of cash flows for each Russell 1000 stock, excluding the Financials and Real Estate sectors (see US Macroscope for details). Our Long and Short Duration baskets are sector-neutral to the Russell 1000.

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