Why did equity markets bounce, if the Fed is keeping interest rates high?

Tim Richardson, CFA explains what the Fed’s Jackson Hole gathering tells us about inflation, interest rates, and share prices.

What’s just happened?

US share markets rose on Friday, with the S&P500 closing up 0.67% and the technology-focussed NASDAQ rising by 0.94%. The markets closed higher over the week, following falls in each of the previous three weeks.

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Why?

Financial markets are growing more confident that the US Federal Reserve (Fed) may have now raised interest rates sufficiently to bring inflation back under control.

Speaking at the Kansas City Fed’s annual symposium at Jackson Hole, Fed Chair Jerome Powell twice mentioned the need to “proceed carefully” in any further move.

This was seen as indicating rates would likely remain on hold at the current range of 5.25% - 5.50% - a 22-year high - at its next meeting in September.

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What does this mean for investors?

The peak in interest rates (or more precisely, an end to unexpected increases in interest rates) will stabilise the equity discount rate which analysts use to calculate the fair value of a company. This should be supportive of equity market valuations which is perhaps why we saw US share markets stabilise last week after the recent falls.

While financial media pontificate at length about whether interest rates have peaked or if another 0.25% rise is to be expected later this year, this arguably misses the wider picture.

There is now a growing level of confidence among investors that:

1. Interest rates are at or close to their peak
2. Having fallen from 9.1% to the current 3.2%, US inflation will continue to fall back to its 2.0% target
3. This will take time, which means interest rates will remain elevated for an extended period, with some investors no longer expecting rate cuts throughout next year; this is reflected in rising bond yields – US two-year Treasury yields rose above 5.0% last week (prices fall as yields rise)

A number of other news items last week indicated a slowing economy, which should help ease inflationary pressures:

• Weaker purchasing managers’ index (PMI) data in the US, Eurozone, UK and Australia showed the slowdown spreading from manufacturing to services, which has been driving inflation for some time
• US July existing home sales and new mortgage applications and August consumer confidence were all weaker, showing that high-interest rates are altering consumer behaviour
• Investment bank Jefferies indicated that higher interest rates are making shoppers more price-sensitive, diminishing companies’ ability to pass through cost increases
• There is currently no sign that China’s Government is bringing forward stimulus measures that might boost aggregate global demand, which means it will continue to export deflation

This appears to imply a macroeconomic environment that can support equity market valuations over the medium term. However, it suggests investors should discriminate in favour of innovative stocks with strong balance sheets and lower sensitivity to the consumer spending cycle - which may be subdued for some time.