Rates Are Rising and Stocks Are Taking a Beating. It Won’t End Soon.

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Uncertainty on several fronts and a fast-changing world—economically, geopolitically, and otherwise—yields known knowns, known unknowns, and unknown unknowns for investors, to cite Donald Rumsfeld’s famous truism during the lead-up to the Iraq war.

The interrelated certainties are that rates are going higher, growth is slowing, and inflation is eating into consumer budgets and company margins. The magnitude of each of the known knowns is up for debate.

The known unknowns include the lingering Covid-19 pandemic and the outcome of the Russia-Ukraine war—as it relates to commodity prices and the not-preposterous talk of a wider and potentially disastrous conflict.

And the unknown unknowns are just that: unknown. But the overall picture is of a market rapidly swinging from rewarding growth at all costs to valuing profits and cash flow above all. Winning stocks and sectors of the past decade are out of favor, and the march higher in bond prices is reversing.

The market reacted violently to the Federal Open Market Committee, which hiked the federal-funds rate target by half a percentage point for only the second time this century. Officials detailed plans to reduce the Federal Reserve’s bloated balance sheet, a process known as quantitative tightening.

The

S&P 500
jumped 3% after Jerome Powell’s press conference Wednesday afternoon, a gain attributed to the chairman taking a 0.75 percentage-point rate hike off the table for the time being. He did say that further 0.5 percentage point hikes would be appropriate at the next few meetings.

By Thursday, investor enthusiasm had evaporated. The S&P 500 dropped 3.6%, and the Nasdaq Composite tumbled a whopping 5%. Bond yields jumped, sending the 10-year Treasury yield to about 3% for the first time since 2018. That’s investors pricing in the known known of benchmark rates continuing to rise this year.

Friday’s April jobs report confirmed the Fed’s trajectory, sending stocks still lower and bond yields higher. With 11.5 million job openings nationwide and fewer than six million unemployed, the labor market is undeniably tight.

That’s a recipe for wage growth, which contributes to broad-based inflation. The Fed can remain focused on the price stability portion of its dual mandate, and not worry about employment. Interest rates are going to continue rising—a known known.

All that weighs on valuations of growth stocks. And when investors can earn 3% or more on a risk-free Treasury note, there’s meaningful competition for slow-growth, dividend-yielding stocks in sectors such as utilities and real estate. Higher rates also mean higher bond yields, especially on the longer-duration end of the spectrum. The

ProShares Short 20+ Year Treasury
exchange-traded fund (TBF) has been a decent hedge so far in 2022, and should continue to be so as rates climb further.

So far this earnings season, S&P 500 profit margins have contracted by almost 4% year over year, per

Credit Suisse
.
Stocks with relatively low valuations and high cash-generating businesses could be the best place for investors to weather the known unknowns. Many of the highest free-cash-flow-yielding stocks in the S&P 500 that trade for below-average earnings multiples are in banking and financials, the rare group that should see core earnings power increase as rates rise. Cheap relative valuations reflect the known unknown of how much the economy will deteriorate this year and next—and whether loan losses will be a result.

Citigroup

(C),

Citizens Financial Group

(CFG),

Synchrony Financial

(SYF), and

U.S. Bancorp

(USB) all screen attractively on those metrics. So do some oil-and-gas producers, which have bucked the trend of contracting profit margins this earnings season, and will continue to benefit from the supply shock of the Ukraine war that has sent energy prices soaring.

APA

(APA),

Marathon Oil

(MRO), and

Occidental Petroleum

(OXY)—a recent Buffett purchase—are potential names there.

Volatility has taken the wheel. Investors ought to buckle up for more bumps ahead.

Write to Nicholas Jasinski at [email protected]