Capital markets undergo notable repricing in response to rising inflation and higher interest rates

Capital markets are in a period of significant asset “repricing” as investors adjust to changing economic conditions. In a rare occurrence, both equity and fixed income markets suffered significant declines over the same period in 2022. 

It marked the end of a strong recovery by stocks following a deep but short-lived bear market that occurred in early 2020. This new phase also represents a striking change for the bond market, concluding a 40-year period where the primary trend was one of low inflation, declining interest rates and stable-to-rising bond prices.

“When interest rates change, all other asset prices change as well,” says Eric Freedman, chief investment officer for U.S. Bank. “If I own a stock that pays a dividend yield of 5%, but bond yields have risen to 6%, I’ll take a harder look at whether it makes sense to own the stock rather than the bond.”

In other words, when interest rates or inflation rise or fall, assets must be ‘repriced’ to reflect this new reality. “Low interest rates and low inflation tend to support higher capital asset prices,” says Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management. “Higher interest rates and higher inflation tend to depress the multiple investors pay for an uncertain stream of future cash flows, such as corporate earnings.”

It’s important to understand why asset repricing is occurring and how to position your portfolio going forward.

What’s driving the markets 

The market’s volatile start to 2022 can be attributed primarily to three key factors:

1. A decline in capital market liquidity. This represents a volume of money that’s working its way through the economy.  In 2020 and 2021, the federal government (through major economic assistance programs in response to COVID-19) and the Federal Reserve (through interest rate cuts and bond purchases) provided stimulus to the economy, creating more investable money. The end of these programs led to a rapid reduction in liquidity. “Lower liquidity doesn’t necessarily mean the markets will fall, but it does create conditions where outside factors can more easily have a negative impact on the markets,” says Bill Merz, head of capital markets research for U.S. Bank Wealth Management. “It creates the potential for more volatility, both on the upside and on the downside, with less money available for investments.”

2. Slower economic growth. Efforts to stimulate the economy in the wake of the emergence of COVID-19 worked, resulting in an economic growth rate (as measured by Gross Domestic Product or GDP) of 5.7% in 2021, the highest annual reading of GDP growth since 1984. “Growth is decelerating now, returning to more normal levels” says Merz. 

3. Persistent inflation. Inflation emerged as a major concern alongside these developments. The most recent readings of the consumer price index (CPI) show inflation at more than 8%, significantly higher than in recent times. Not since the early 1980s has inflation been this high. 

The Fed makes an impact

In March, the Fed initiated two policies to try to scale back the inflation threat, both seeking to limit liquidity in the markets. These recent pivots in its monetary policy appear to have altered investor sentiment.

• First, the Fed began raising the short-term interest rate it controls – the fed funds rate – for the first time since 2018. Fed chairman Jerome Powell made clear that interest rate hikes will continue at least through 2022.

• Second, the Fed ended its program of “quantitative easing,” or monthly injections of $120 billion in bond purchases. Additionally, the Fed will begin scaling back asset holdings it accumulated through quantitative easing in the months to come, removing even more liquidity from the bond market. 

“The Fed’s policy shift is the primary reason bond markets reacted and interest rates began to move up across the board,” says Merz. “Its actions contributed to the drop in liquidity that is being felt in capital markets.” 

Higher interest rates also directly impact the stock market. “Two factors drive stock prices – the level of earnings, and the multiples that investors are willing to pay for earnings,” says Haworth. While corporate earnings (profits) have held up well in 2022, multiples, which are typically reflected in the price-to-earnings ratio of a stock, have been falling. 

“Multiples tend to be higher when interest rates are low,” says Haworth, “but this year, higher interest rates mean investors are less willing to pay up for stocks.” Higher rates make bonds, which generally carry less risk than stocks, a more desirable investment consideration. “The more attractive income a bond can generate, the less appealing it is to pay high prices for stocks based on the uncertainty that future earnings will continue to flourish,” says Haworth. As a result, the investment environment has become more challenging for stock prices. 

An unusual environment that will pass

Freedman and Merz agree that the repricing that’s occurred to this point is largely attributable to the Fed’s change in policy direction, as it pulled back on interventionist measures. “We’re really in the middle of that stage at this point,” says Freedman.

There is a risk of assets repricing further under certain circumstances, Freedman believes. “If we see higher commodity costs as well as higher borrowing costs trickle into the real economy and stay there for some time, there would be reason for further caution by investors.” 

Yet Freedman says the current unusual environment, where both stocks and bonds suffered losses simultaneously, will pass. “We will get to a point of stability,” says Freedman. “The underlying economy has not changed directionally. We don’t expect that today’s high inflation scenario will become a permanent feature, but it could stick around for longer than we hoped.”

Merz sees reasons for some optimism as the year progresses. Consider that yields on 10-year U.S. Treasury bonds more than doubled, from 1.5% at the start of the year to above 3% in early May. Merz believes this significant jump in yields reflects investors already “pricing in” additional rate hikes by the Fed. “Based on how bond math works, it would be challenging for yields to continue to rise at the pace we’ve seen in the early part of the year.” While interest rates may move higher from here, Merz believes the changes will be less dramatic.

Additionally, Merz believes many credit issuers are in a strong financial position. “There is little risk of a significant jump in credit defaults in the corporate bond market,” says Merz. That fact, along with the reality that today’s elevated yields are likely to boost demand for bonds, should help provide more stability for the fixed income market in the months ahead.

Merz suggests the same thing is happening in the stock market. “We see strong earnings growth with little chance of it faltering much,” says Merz. That should create an improved environment for stocks, but Merz says investors should be prepared for continued market volatility. Inflation trends could be an important indicator. “If the Fed succeeds in tamping down the inflation risk more rapidly than many anticipate today, it would be a favorable development for risk assets,” says Merz.

How to proceed from here

While the current environment has been challenging, Freedman recommends that investors maintain a longer-term perspective. He says while it’s easy to get distracted by the constant flow of news, it’s important to distinguish between what is notable and what is simply “noise.” Investors should avoid making changes to their portfolio in reaction to short-term market developments.

A better approach is to have a well thought out plan that serves as the focal point for key investment decisions. “If you don’t have a plan that’s reflective of who you are and the goals you are pursuing, work with a professional to get one,” says Freedman. “A plan is the foundation of a sound investing strategy.”

Talk with your wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio remains consistent with your long-term financial goals.