How 5% Interest Rates Won't Derail The U.S. Stock Market Or Economy

At the beginning of 2023, the U.S. stock market started gaining ground, recovering a sizable portion of the agonizing losses from the previous year. The Federal Reserve will need to decrease interest rates this year to avert a recession, reversing one of its fastest rate-increasing campaigns in history, according to the belief behind the upbeat tone.

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Doomsday investors have warned against such eventuality, notably hedge fund billionaire Paul Singer. After a period of almost low-interest rates, Singer believes that a credit crisis and severe recession may be required to clear the markets of dangerously high levels of froth.

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Another possibility is that little changes: credit markets could accept pre-2008 interest rates. The Fed's policy rate might rise somewhat from its current range of 4.75%-5% and remain there for some time.

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In a phone interview, Ben Snider, managing director and U.S. portfolio strategist at Goldman Sachs Asset Management, said that "A 5% interest rate is not going to destroy the market."

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Snider cited several highly rated corporations that, like the majority of US homeowners, refinanced previous debt during the epidemic, lowering borrowing prices to near-record lows. "They are still benefiting from the cheap interest rate environment," he added.

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"In our opinion, the Fed can hold rates here," Snider said. "The economy has the potential to expand further."

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Profits margins in focus

In the aftermath of the epidemic, the Fed and other global central banks have drastically increased interest rates to combat inflation induced by supply chain disruptions, labor shortages, and government spending initiatives.

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Fed Governor Christopher Waller warned on Friday that interest rates may need to rise even more than markets currently anticipate to contain the rise in the cost of living, which was recently reflected in the March consumer-price index at a 5% annual rate, down from the central bank's 2% annual target.

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In 2022, the unexpected spike in interest rates resulted in significant losses in stock and bond portfolios. Rising interest rates also played a part in Silicon Valley Bank's demise last month, when it sold "secure" but rate-sensitive products at a severe loss. This generated concerns about the vulnerabilities in the US financial sector, as well as fears of a credit crisis.

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"Rates are higher than a year ago and higher than in the previous decade," said David Del Vecchio, co-head of PGIM Fixed Income's U.S. investment grade corporate bond team. "Yet, when seen over longer periods, they are not that high."

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When investors purchase corporate bonds, they frequently consider what may go wrong and prevent them from receiving a complete return on their investment plus interest. To that end, Del Vecchio's team expects corporate borrowing rates to remain higher for longer, and inflation to continue over the goal, but also evidence that many highly rated firms may start well if a recession occurs soon.

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"Profit margins have been declining (see figure), but they are still below peak levels," Del Vecchio explained. "They're still quite powerful and heading lower." It is likely to continue to fall this quarter."

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Rolling with it, including at banks

There are many reasons why equities might still fall in 2023, painful layoffs could occur, and problems with a wall of aging commercial real estate debt could send the economy into a tailspin.

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Goldman Sachs Asset Management's Snider anticipates the S&P 500 index SPX, -0.21% to conclude the year around 4,000, or essentially flat to its Friday closing level of 4,137. "I wouldn't describe it as bullish," he added. "But, it isn't quite as awful as many investors anticipate."

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"Some highly leveraged firms with debt maturities in the near future will struggle, and may even struggle to keep the lights on," said Opal Capital's chief investment officer, Austin Graff.

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But, the economy is unlikely to "enter a recession with a boom," he said. "It will most likely be a sluggish fall into a recession as businesses tighten their belts and cut expenditure, which will have a knock-on impact throughout the economy."

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Graff, on the other hand, views rising rates as beneficial for large banks that have better-controlled interest rate risks in their securities holdings. "Banks may be quite lucrative in the present rate environment," he added, citing huge banks that traditionally provide 0.25%-1% on client deposits but can now lend money at rates as high as 4%-5%.

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"The spreads the banks are generating in today's interest rate market are astonishing," he remarked, citing JP Morgan Chase & Co. JPM, +7.55% provided projections that include an expected $81 billion in net interest income for this year, a $7 billion increase over last year.

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According to Del Vecchio of PGIM, his team is still expecting a reasonably brief and weak recession, if one occurs at all. "You might have a situation where it's not a synchronized recession," he explained, adding that a downturn can "roll across" different areas of the economy rather than happening all at once.

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The housing market in the United States has slowed sharply in the last year as mortgage rates have risen, but it has recently shown indications of improvement, with "travel, accommodation, and leisure all performing well," he added.

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Stocks in the United States ended the week down but with a run of weekly advances. According to FactSet, the S&P 500 index has gained 0.8% in the last five days, the Dow Jones Industrial Average DJIA, -0.42% has gained 1.2%, and the Nasdaq Composite Index COMP, -0.35% has gained 0.3% for the week.

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More Fed speakers will address investors next week, ahead of the central bank's next policy meeting in early May. Housing-related statistics will be released in the United States on Monday, Tuesday, and Thursday, with the Fed's Beige Book coming on Wednesday.

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