- The S&P 500 is trading 8% higher today than it was before the Fed started hiking rates last spring.
- That's surprising as higher rates hit earnings and economic growth, and make stocks less appealing.
The S&P 500 is trading 8% higher today than before the Federal Reserve began its flurry of interest-rate hikes last spring. That's surprising for a bunch of reasons — but perhaps it shouldn't be.
The benchmark US stock index closed at 4,720 points on Thursday, compared to 4,358 points on March 16 last year, the day before the Fed began its latest hiking cycle. The US central bank went on to raise its benchmark rate from nearly zero to upwards of 5.25% — a 22-year high — in the space of just over 16 months. It has held rates steady since July.
The Fed hiked in response to a historic spike in inflation. Annualized price growth hit a 40-year high of over 9% last summer, far outpacing the central bank's 2% target. Higher rates encourage saving over spending and make borrowing more expensive, which tends to temper overall demand in the economy and slow the pace of price increases.
The rate hikes work in part by squeezing consumers, forcing them to allocate more of their monthly incomes toward the bigger payments due on their credit cards, car loans, mortgages, and other debts. American households have also faced soaring food, fuel, and rent costs, which have stretched their budgets even more.
Between inflation in living expenses and higher debt costs, consumers have been left with less disposable income to spend on goods and services produced by companies, hurting sales. Corporations have also seen their costs and interest payments jump, pinching their profit margins.
A company's shares are generally valued at a multiple to its future earnings, meaning if investors expect its profits to grow less quickly or even shrink, its stock price should come down. Stocks also become relatively less appealing to investors when rates rise, as the returns from safe assets like savings accounts and government bonds increase.
Stocks are valued based on their future cash flows, so if investors see companies struggling to raise prices to protect their profit margins from inflation, and spending more to cover their debt costs each month, they'll reduce their cash-flow forecasts and assign a lower value to their shares today.
Moreover, hiking interest rates can slow the economy so much that it enters a prolonged downturn or recession. Consumers tend to pull back on spending and investors flee to safety when they fear economic pain, providing another reason why stocks tend to suffer when rates increase.
Between elevated inflation, a rapid-fire series of rate hikes, and the increased risk of a recession, there are clear pressures on stocks today. On the other hand, inflation has cooled to below 4% in recent months, the US economy grew strongly in the third quarter, and the Fed signaled this week that it expects to cut rates three times next year. The stock market prices in future expectations, and may reflect investors' optimism that prices are under control, a recession will be avoided, and rates will come down soon.
Ben Inker, the co-head of asset allocation at elite investor Jeremy Grantham's GMO, recently offered two more reasons why stocks are worth more today than a couple years ago. Inflation has boosted the fair value of stocks, because companies produce the goods and services that have climbed in price, he said. The US economy has also grown, and companies tend to grow alongside the wider economy, raising the fair value of stocks once again, he said.
It may be jarring to see the S&P 500 trading 8% higher today, when rates are over 5%, than its level when rates were almost zero. Investors may simply believe the worst of the economic pain is over, and the future is so bright for stocks that they're worth more today.