A New Interest-Rate Regime Has Begun. These Are the Market’s Winners and Losers.
Bond prices, the Magnificent Seven and emerging markets are under pressure
Investors are struggling to make peace with a new reality: Interest rates are likely to remain higher for longer.
Stocks have tumbled, government-bond yields have risen and the U.S. dollar has climbed since Federal Reserve officials signaled two weeks ago that they might hold rates near current levels through 2024.
Entering the fourth quarter, the S&P 500 is hanging on to a 12% advance for the year, but much of the enthusiasm that characterized markets in the first half has largely disappeared.
“It’s a whole different mindset,” said Sandi Bragar, chief client officer at wealth-management firm Aspiriant. “Investors knew this was a possibility, but they were choosing to ignore it.”
In the coming days, investors will be looking at Monday’s manufacturing data and Friday’s monthly jobs report as they try to assess the strength of the economy and the market’s trajectory.
Here’s how the new interest-rate regime is forcing money managers to adjust their investing playbooks.
Bond prices are declining—again
Bonds had a historically terrible year in 2022. Those who bet 2023 would be better have been wrong thus far.
Government-bond yields, which move inversely to prices, started climbing again in July when a flurry of stronger-than-expected data persuaded investors that the Fed would have to keep interest rates elevated to cool the economy. Then in August, the government said it would sell many more Treasurys in coming months than investors expected, extending the summer losses and forcing traders to reassess their outlook for the market.
Expectations for higher interest rates drive down bond prices because investors worry that bonds issued in the future will pay larger coupons than current ones. That, in turn, pushes up yields, a measure of annualized expected returns that assumes bonds will be paid at their face value at maturity.
The yield on the 10-year U.S. Treasury note briefly climbed above 4.6%, its highest level since 2007, from 3.818% at the end of June. The iShares Core U.S. Aggregate Bond ETF—which largely holds U.S. Treasurys, highly rated corporate bonds and mortgage-backed securities—is on pace to fall 3% in 2023, which would mark an unprecedented third consecutive annual decline.
The Magnificent Seven are losing their shine
Big tech stocks were so dominant to start the year that they earned a new moniker: the “Magnificent Seven.” Apple, Microsoft, Alphabet, Amazon.com, Nvidia, Tesla and Meta Platforms were responsible for virtually all of the stock market’s advance at one point this spring.
That trade is now showing cracks, while investors look with renewed skepticism at the hefty valuations commanded by the market leaders. Shares of Nvidia fell 12% in September, Apple slid 8.9%, and Amazon dropped 7.9%. Only Meta notched a gain.
When interest rates are low or soon expected to fall, traders are willing to pay higher multiples of a company’s near-term earnings to share in its far-off growth.
The calculus changes once investors brace for a period of higher rates. They have less incentive to buy risky assets such as tech stocks when they can earn 5% in a money-market fund or high-yield savings account.
After this year’s rally, some of the stocks look pricey relative to history. Apple is trading at roughly 26 times its expected earnings over the next 12 months, while Microsoft’s multiple is about 27. Their 10-year averages are around 18 and 23, respectively.
“If you think about the tremendous outperformance of the Big Seven names in the first half of the year, it is just mathematically, extraordinarily unlikely that we see that happen again,” said Kara Murphy, chief investment officer at Kestra Investment Management. “Even if those names don’t go down, some of the leadership has to change.”
Shares of dividend payers are under pressure, too
Steady income from stocks doesn’t hold the same appeal it used to.
Fewer than 30 stocks in the S&P 500 have a dividend yield above that on the six-month Treasury bill, according to FactSet.
That is a shift from much of the past decade when interest rates were near zero and hundreds of stocks within the index offered higher yields. At the end of 2021, before rates began to rise, there were 379 index constituents that offered a better yield than the Treasury bill, according to Birinyi Associates.
Investors see little reason to own dividend-paying stocks when yields are rising on risk-free government bonds. Besides, the stocks aren’t offering enough extra yield to compensate for the risk of a slowdown in business activity.
Among the dividend-paying stocks slumping of late are Dollar General and Estée Lauder, down 37% and 25%, respectively, over the past three months.
Small-caps are falling faster than their larger counterparts
Shares of small-caps have been one of the biggest market laggards this year. Investors don’t expect that to change anytime soon.
The Russell 2000 has declined 11% from its July high, trailing the S&P 500, which has fallen 6.6%.
Investors worry that if interest rates stay higher for longer, it could kick off a recession in the U.S. That could further drag down shares of small, speculative companies since they tend to be sensitive to the health of the economy. They also typically generate most of their income domestically and have weaker balance sheets compared with large multinationals.
Shares of Rent the Runway declined 66% in the third quarter, while JetBlue Airways fell 48%.
Emerging markets are slumping while the dollar climbs
The U.S. dollar has risen more than 5% since mid-July, driven by surging Treasury yields and strong economic data. That has been particularly painful for emerging markets, making it more expensive for those countries to buy goods priced in dollars or service their dollar-denominated debts.
Interest rates have shot up in many developing countries as well, putting strain on the global financial system. Together with rising oil prices, higher rates and a soaring dollar are threatening growth around the world and raising worries of more financial fragility.
The Argentine peso dropped about 25% in the third quarter, while the Chilean peso fell roughly 10%. Meanwhile, MSCI’s benchmark index of emerging-markets stocks declined 4.4% over the same period.
The dollar has risen in eight of the past 10 weeks to its highest level since November.