What Happens When Rates Rise?
The Federal Reserve will raise interest rates starting in the next FOMC meeting in March with a 25bp hike to the fed-funds rate. Investors continue to evaluate the best way to position their investment portfolios under a rising rate environment.
While economists believe inflation will run hot for months before moderating during the second half of the year, the market is pricing in three to four rate hikes bringing the fed-funds rate to 1.00-1.25% by year-end.
Inflation has also climbed to the highest levels since 1982 on the backdrop of supply chain bottlenecks, the effects of monetary and fiscal stimulus, rising commodity prices, strong job markets, and rising asset prices.
If the above does not confuse investors, we remain in a once-in-a-century pandemic with escalating geopolitical tensions.
When the Fed raises rates, the popular belief is value-related sectors such as financials will benefit from higher interest rates. Also, higher interest rates will hurt expensive growth stocks, many of which are in the technology sector.
Are the consensus views correct?
Historically, higher rates have been mostly positive for financials, but it is also not damaging to the technology sector. There are few periods in history that resemble today, at least from an interest rate and inflation perspective.
Sector leaders and laggards will depend predominately on the pace of Fed hikes and whether this leads to a soft or hard landing. Remember, the monetary actions from the central bank only impact short-term rates. Two factors drive longer-term rates – future economic growth or the lack of it (i.e., inflation, recession, etc.) and the structural changes in investor psychology (i.e., investment sentiments).
Higher interest rates are favorable to most financial companies for obvious reasons. Banks benefit from rising net interest margins. As the spreads between the rate banks pay their customers for deposits and the rates the banks charge their clients increase, the bank revenues also increase. In addition, in a rising-rate environment, the valuations of value-related stocks and sectors become even less expensive against their growth counterparts, attracting more value-driven investors.
See the enclosed chart showing the relative performance of the S&P financial sector relative to the S&P 500 Index and the 10-year US Treasury yield.
In the expectation of higher rates, many investors are concerned about high valuation stocks and sectors such as technology and growth stocks in general. The extremely low-interest-rate environment has boosted the valuations of many growth and technology companies since the earnings of growth stocks or future cash flows grow faster than value or other investment styles, at least on a relative basis and over the long term. On the other hand, as rates move up, this will lower the value of those future cash flows, hence a slowdown in the future valuations of growth and technology stocks, all else being equal.
The above scenario implies higher interest rates are bad for growth and technology stocks. However, higher interest rates are not necessarily negative for growth and technology stocks. It is not as simplistic as it sounds. It depends on many other variables. For instance, higher inflation can lead to higher interest rates. But it can also lead to increased revenues and higher earnings, resulting in higher future cash flows. A growth or technology company that can increase productivity via cutting edge technology such as automation and innovation can still achieve higher revenues and superior cash flows to command the high valuations.
Some believe technology and a growth stock performance depend on capital expenditures and specifically business investment in technology. There is a stronger correlation between the growth in business investment and the relative performance of the technology sector. Although a low-interest-rate environment can lead to technology and growth stock relative outperformance, a moderately rising interest rate environment with inflation does not necessarily hurt innovative growth companies that maintain their high growth rates.
Attached below is a chart of the S&P 500 technology sector relative to the S&P 500 Index and the 10-year US Treasury yield. It appears that historically interest rates do not impact the technology sector's performance.
A volatile period is likely as the Fed hike interest rates to tame inflation. If the Fed raises rates in moderation and under a slow and deliberate tightening process, history shows that this could lead to favorable outcomes in the financial and technology sectors.