How Volatile Interest Rates Affect U.S. Equities

Welcome back to our latest edition of Market Insights with Sanjeev Kaushik.

In this newsletter, we explore the fascinating interplay between interest rate swings and the U.S. stock market.

Read on to uncover how even small shifts in rates can send ripples through various sectors, influencing market sentiment and investor decisions.

1. Why Rate Changes Keep Wall Street on Its?Toes?

The relationship between interest rates and the stock market is like a dance?—?sometimes in harmony, sometimes in conflict, but always interconnected.

Recently, this dynamic has been on full display as the S&P 500 dropped by 3% since early December, while the 10-year US Treasury yield surged by 64 basis points (bps) before easing slightly.

Let’s explore what this means for investors, how it affects stock valuations and earnings, and where opportunities might lie in a shifting market.

1.1 Rate Spikes and Market?Jitters

The 10-year Treasury yield, a critical benchmark for borrowing costs and investment decisions, has surged 46 basis points from its recent low.

Historically, sharp rate increases?—?like the recent 60 basis point jump?—?tend to rattle stocks. Over the past 20 years, such moves have resulted in average market declines of 4%.

This time around, the S&P 500 slipped 3%, while the Russell 2000, which tracks smaller companies, took a heavier hit, falling 6%. The takeaway? Sudden rate hikes amplify market anxieties, leaving investors on edge.

1.2 How Interest Rates Affect Stock Valuations

Stocks are priced based on future earnings, and interest rates play a big role in determining how much those future earnings are worth today.

The current price-to-earnings (P/E) ratio of the S&P 500 is 22x, which seems fair given today’s rates, according to Goldman Sachs. But here’s the catch:

• A 50 bp rise in real yields (adjusted for inflation) could push the S&P 500’s fair value P/E down by 3%.
• Persistent rate increases can also pressure company earnings, but most S&P 500 firms are well-prepared. About 94% of their $6.2 trillion in debt is at fixed rates, with more than half maturing after 2030.

While rising rates can create headwinds, many large companies have strategies to weather the storm.

1.3 What About Earnings?

The good news: Modest changes in interest rates won’t drastically alter earnings for most companies. Here’s why:

1. Limited Impact on Borrowing Costs: Most S&P 500 companies have locked in low rates on their debt for years to come.
2. Sector-Specific Benefits: Financial companies (like banks) often benefit from higher rates, offsetting some of the challenges faced by other sectors.

Even if the 10-year Treasury yield rises by 100 bps, it’s likely to trim US GDP growth by only 0.5% over the following year. This translates to a small 2% dip in earnings per share (EPS) for 2026?—?not great, but not catastrophic either.

1.4 Winners and Losers: Sector Performance

Not all sectors react the same way when interest rates climb. Here’s a closer look at how various parts of the market are faring amid the latest rate moves:

Big Tech Defies the Odds

Tech giants like Amazon, Tesla, Meta, and Alphabet have shown remarkable resilience, continuing to outperform the broader market. These companies benefit from strong growth prospects and robust balance sheets, making them less vulnerable to higher borrowing costs compared to other industries. Their ability to innovate and expand despite economic headwinds keeps them a favorite among investors.

Commodities Face Challenges

The Energy and Materials sectors have struggled to keep pace as rates rise, underperforming compared to their usual market behavior. While Energy stocks face pressures from higher borrowing costs and demand concerns, Materials have maintained their appeal for long-term investors due to their foundational role in global infrastructure and industrial growth.

Rate-Sensitive Stocks Show Strength

A group of interest rate-sensitive stocks has emerged as a consistent performer, outperforming the broader market since the upward trend in rates began. These include companies in sectors like financials, which benefit from higher interest margins, and utilities, which offer steady returns that appeal to cautious investors during volatile times.

Rising rates don’t affect every corner of the market equally, and these dynamics create unique opportunities and risks for investors to consider.

1.5 What’s Next for Interest Rates and?Stocks?

S&P 500’s P/E ratio is expected to hover around 22x.

Goldman Sachs forecasts a slight dip in the 10-year Treasury yield, projecting it to reach 4.35% by the end of 2025. The reasoning behind this expectation includes slowing inflation and a more dovish stance from the Federal Reserve.

If this outlook holds, here’s how it could shape the market:

Valuations Stay Steady

With a less volatile interest rate environment, the S&P 500’s price-to-earnings (P/E) ratio is expected to hover around 22x, providing a stable foundation for equity markets.

Earnings Drive Growth

As valuations stabilize, rising corporate earnings will likely become the primary driver of market gains. Companies with strong earnings growth potential could see outsized performance.

Upside Potential for Stocks

Goldman Sachs has a bullish outlook, targeting a 9% gain in the S&P 500, which could push the index to an impressive year-end level of 6,500.

If these projections play out, the coming years may offer a more predictable environment for investors, with opportunities for growth tied closely to the health of corporate earnings.