Interest rates

Rising interest rates can lead to revaluations in stock, bond and real estate markets

Key points to remember:

  • Stock index futures rebound after overnight selloff as investors try to hold on to gains
  • Stocks fell on Tuesday as interest rates and oil prices plus a rare Goldman Sachs failure
  • Investors are forced to reassess valuations when interest rates rise

Stocks are looking to rebound on Wednesday from Tuesday’s selloff as stock index futures point higher. Futures fell overnight but rebounded along with European markets. London’s FTSE 100, Germany’s DAX, France’s CAC 40 and Stoxx 600 advanced. However, there are a number of earnings announcements for investors to sort through on Wednesday. Financial companies continue to dominate the reports, but there are other companies worth mentioning.

Starting with finance, Morgan Stanley

MRS
(MS) and Bank of America

BAC
(BAC) both beat earnings estimates despite no revenue while US Bancorp

TBBK
(USB) missed on upper and lower line numbers. These stocks were moving in premarket trading with MS up 2.38%, BAC up 2.62% and USB down 4%. According to Barron’s, BAC appears to have had the best quarter due to its ability to control expenses.

Outside of finance, UnitedHealth

A H
(UNH) reported better-than-expected earnings and revenue, but rose just 0.35% in premarket stock. The health care and insurance company was able to avoid higher expenses related to the increase in COVID-19 Omicron cases. Revenue from the company’s Optum Health service rose 14% in the prior quarter to $41.1 billion.

Supplier of industrial, construction and safety products Fastenal

QUICK
(FAST) beat earnings and revenue, driving pre-market trading up 1.9%. FAST, it seems, has not has been hit by rising inflation, and a company like FAST that specializes in selling many low-priced items like screws, nuts, and bolts can be seen by some investors as a good indicator of demand and economic strength. FAST also announced a dividend increase.

After Tuesday’s shutdown, trucking company JB Hunt (JBHT) reported better-than-expected profits and revenue despite lower haul volumes due to COVID-19-related labor shortages, inclement weather and train derailments. The company saw a 22% increase in revenue per load, excluding fuel surcharges. JBHT rose 0.10% in after-hours trading.

The question of the day is, “Can we sustain the higher levels that stock index futures are pointing to?” It was difficult to hold on to the gains, especially in the first half hour. However, yesterday’s sell-off was very orderly and never really “out of control”, which could indicate that investors are simply repricing assets in light of rising interest rates and not panic sales.

To sell

Rising interest rates and oil prices, with some failures of large financial companies like Goldman Sachs (GS

GS
), appear to have been too much for investors who were selling stocks on Tuesday. The VIX (Cboe Market Volatility Index) rebounded 18.76% to 22.79, reflecting heightened investor uncertainty around financial markets. The S&P 500 (SPX) fell 1.84% as investors sold stocks. However, investors were also selling bonds, pushing the 10-year Treasury (TNX) yield up 5.25% to 1.865%. In contrast, the 10-year yield closed at 1.343% on December 3, 2021, its recent low.

The main stock indices have been falling since the beginning of the year. The Dow Jones Industrial Average ($DJI) is down 2.7% year-to-date. The S&P 500 (SPX) fell 4%. The Russell 2000 (RUT) fell 6.6% and the Nasdaq Composite (COMP:GIDS) is approaching the correction zone after closing Tuesday at 7.3% year-to-date.

One asset investors seem to be buying is crude oil. Oil prices rose 2.74%, surpassing their November 2021 highs and setting a new seven-year high. Rising oil prices appeared to help energy stocks, which were the best performing sector as all other sectors ended in the red. Rising rates normally help financial stocks, but they were the worst performing sector of the day due to earnings losses.

The 2-year Treasury yield also broke above the 1% mark. Some investors may see this as a sign that the Fed is going to raise rates more than Chairman Jerome Powell originally expected. After the December Fed meeting, Chairman Powell said the Fed was targeting 0.90% by the end of 2022. The 2-year yield tends to be the most correlated to Fed moves, that is is why investors are now eyeing the potential that the Fed may need to raise rates higher and sooner. The CME FedWatch Tool is currently pricing in a 91.6% chance that the Fed will raise the policy rate by a quarter point in March.

The evaluation variable

When interest rates reach a certain level, many investors reassess their investments and change their price targets. This is because equity valuation tools like the discounted future cash flow model use interest rates to help determine a company’s intrinsic value. Intrinsic value is a measure of the value of a business or an asset. The model looks at the growth rate of a company’s earnings over a period of time, then discounts those earnings to present value dollars using the “risk-free” rate of return, which is typically the 10-year Treasury yield. The higher the yield, the less that future income is worth.

But the 10-year yield is not the only factor that can change valuations. Rising business costs like inflation and rising borrowing costs due to higher interest rates could also lower the estimate of future earnings growth or reduce the price multiple that investors are willing to take. to pay for the action. There are other variables at play when calculating intrinsic value, but interest rates are important.

Valuations are likely the main driver behind the recent outperformance of the S&P 500 Pure Value Index relative to the S&P 500 Pure Growth Index. On November 19, 2021, the value index surpassed the growth index in relative strength. Since then, the value index has risen by more than 8%, while the growth index has fallen by almost 14%. The S&P 500 also fell just over 2% over the same period. And, apparently, investors are finding the most value in energy stocks, as the Energy Select Sector Index is up 20% over the same period.

One group to watch could be pandemic stocks as investors struggle to value these stocks if we return to a more “normal” pre-pandemic lifestyle. Many of them like Zoom (ZM) and Peloton (PTON) are struggling to find a landing spot. ZM is down more than 70% from its October 2020 pandemic high, while PTON is down more than 80% from its January 2021 high. Investors may struggle to value these stocks in the future due to the uncertainty surrounding the business climate.

Yielding land: My technical analysis friends tell me that we can use long-term charts to get an idea of ​​how interest rates might rise further. The 10-year Treasury yield recently broke above its 2021 highs or resistance. The next level of resistance is likely around the 2% level. Depending on how long it takes for the yield to reach resistance, this could mean more volatility for stocks in the short term.

Breaking links: Rising yields also mean that the bond market is likely to continue falling as bond prices and bond yields move in opposite directions. However, rising yields will eventually attract income investors from other assets that pay higher dividends, such as utility stocks or real estate investment trusts (REITs). This is because the higher Treasury yields and safety associated with government bonds tend to be more attractive to income investors. Over the past three months, we have seen this play out. The Utilities Select Sector Index was up about 10%, but peaked early in the new year and fell more than 4%. Similarly, the Real Estate Select Sector Index had risen around 13% at the start of the new year, but is now down around 7.5%.

Mortgage the future: The housing market could also be struggling as the 30-year mortgage rate is generally correlated to the 10-year Treasury yield. The US 30-year fixed rate mortgage average closed last Thursday at 3.45% according to FRED, but this morning the Mortgage Bankers Association reported the 30-year mortgage at 3.64%. To put that into perspective, the 30-year mortgage bottomed on January 7, 2021 at 2.65%.

According to SFGate, a 0.25% increase in a mortgage rate could add about $20 to the monthly payment for every $100,000 on the loan. Of course, with the homebuilder backlog accumulating, a little less heat might be welcomed by homebuilders and their suppliers, which is one of the reasons the Fed is raising rates.

So far, the housing market appears to be holding up. This morning December building permits were higher than expected. Although housing starts were lower than the previous month, they were also higher than expected in December.

TD Ameritrade® Commentary for educational purposes only. SIPC member.