Higher interest rates not so scary after all

“Higher for longer” just doesn’t have the same fear factor that it used to.

Nine months ago, the idea that Fed cuts would be delayed and interest rates would remain elevated was enough to trigger the largest stock selloff of 2023, an 11% correction that had some questioning the staying power of this bull market. The pessimism subsided by late October, and the S&P 500 has since rallied 30%, even though interest rates have barely declined.

It’s true that some of the gains can be attributed to anticipation of cuts from the Federal Reserve, but those expectations have moderated significantly. Wall Street forecasts suggest only one to two rate cuts by year’s end, down from six projected cuts at the start of 2024.

Why then are stocks performing so well despite no Fed stimulants in the punch bowl? There is a growing realization that higher interest rates are not so bad for the economy and the stock market after all.

Many seasoned investors already know this, of course. The S&P 500 returned an average of 13.2% per year in the 1980s and better than 16% annually in the 1990s, decades when U.S. Treasury yields were consistently higher than they are now. It is also not the case that higher rates lead to more (or deeper) recessions.

So, history tells us that equities can weather a storm of higher rates. Additionally, the modern economy and stock market may also be better insulated from these same hazards.

Unlike the ‘80s and ‘90s, when interest rates were trending lower from recent highs, rates this time have climbed from all-time lows. Most consumers and businesses with sizable debt in 2024 have already locked in fixed mortgages or loans at rates lower than what is available today.

Monthly payments therefore remain steady, and there is little incentive to aggressively pay down debt when money market funds pay higher interest than what is owed. This leads to higher discretionary income, which helps explain why consumer spending has remained so strong despite stubborn inflation readings.

The S&P 500, meanwhile, appears particularly well-fortified. The six largest companies (Microsoft, Nvidia, Apple, Alphabet, Amazon and Meta) comprise more than 30% of the index. And all of them, with the potential exception of Amazon, are “asset-light” technology giants with revenue streams less affected by higher rates and inflationary pressures.

Unlike a home builder whose profit is affected by the cost of lumber or steel, Microsoft and Apple do not pay higher material costs when they release a new operating system. Software can be downloaded and delivered extremely efficiently while the company maintains pricing power to raise asking prices in accordance with inflation.

Rising labor costs still affect tech companies. And some components integral to their devices, like gold, have become more expensive. The technology sector is not immune to inflation and higher rates, but it is better able to overcome these challenges.

Service-based industries as a whole tend to be less sensitive to higher interest rates, provided the majority of their debt remains fixed. An estimated 70% of the U.S. economy is made up of service industries like software, finance and health care.

The caveat is that even with a more resilient economy, growth is not inevitable. U.S. GDP slowed to 1.3% annualized in the first quarter and the higher rates we are discussing have yet to successfully kill inflation. Eventually, fixed-rate loans will mature, debt service will climb and spending will slow.

Still, investors can take heart knowing that higher rates are not especially detrimental to their portfolios.

Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at ben.marks@marksgroup.com. Brett Angel is a senior wealth adviser at the firm.