What Rising Interest Rates May Mean for Stocks and Bonds

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The Federal Reserve has begun to raise interest rates, and it's signaled that there's more to come. Joining me today to talk about what rising interest rates may mean for the stock and bond markets is Dave Sekera. Dave is Morningstar's chief U.S. market strategist.

Hi, Dave.

Dave Sekera: Hey, Susan.

Dziubinski: Let's dive right in and talk about the big picture. What do you see going on with interest rates in 2022?

Sekera: We expect interest rates are going to continue to keep rising even from here. And I'd break that into two different parts of the yield curve. So, there is the short-term part of the yield curve and the longer-term part of the yield curve. Now, in the short term, we're looking at the Fed raising interest rates, the federal-funds rates, multiple times this year. And according to the Fed's projections, they're looking at getting up to about 2% by the end of this year, and in fact, next year, getting up to about 3%. So, short-term rates are going to be very correlated with the Fed's moves.

Now, the longer-term interest rates are really going to be based more on the macroeconomic outlook than it is going to be on the Fed's necessarily short-term rate movements. We're looking at a couple of different factors there. First is inflation. Now, inflation is running hot. We expected it to run hot at the beginning of this year. But now, with the conflict in Ukraine and seeing some of the spikes in commodity prices, inflation is going to be running hotter than what we originally had thought. Now, we still expect it to moderate in the second half of this year, but we did recently bump up our inflation forecast for this year to 4.3%. But then, we do expect it to come down below 2% next year and then average about 2% thereafter. Now, historically, long-term interest rates do have a term premium over inflation. So, that actually probably bring us up to about 3%, that area, once we get back to more of a normalized environment.

The other part I'd mention, too, is that we do look at the market-implied inflation expectations. So, on the shorter term, there is the five-year breakeven rate, and we've seen that going up, and in fact, I believe that's at its highest level over the past 20 years. And then, looking at longer-term inflation expectations, we look at what's known as the five-year, five-year forward breakeven rate. So, again, what that does is that measures what the inflation expectations are for five years starting five years into the future.

And finally, the other thing that I'm watching is that the Federal Reserve had had their asset purchase program for about two years since the beginning of the pandemic and just recently ended that purchase program. This summer we're waiting for more information from the Fed as far as what their plans are to do with the huge balance sheet that they now currently have. We do expect that they'll probably start selling off some of the bonds on their balance sheet later this year, and that will certainly change the supply-demand characteristics in the bond market as well.

Dziubinski: Let's talk a little bit more about bonds. Let's say I'm an investor who wants to be focused on high-quality bonds. Where on the yield curve should I think about being if what I'm trying to do is mitigate my interest-rate risk?

Dziubinski: We have seen a pretty big bump up in short-term interest rates because of the movements from the Fed. Again, if you really want to completely minimize any interest-rate risk, of course, you'd have to stay at the very short end of the yield curve. But I think investors right now can go a little bit further out the yield curve and get that additional yield pickup. And so, I'd look at what we call like the middle of the curve, maybe around that five-year point today. I think that's probably going to be the best risk/reward trade-off for investors.

Dziubinski: Let's talk a little bit about investors who may be willing to dip a toe or maybe more than a toe in the corporate-bond market. Tell us a little bit about where you see higher-quality corporate bonds versus junk today?

Sekera: Sure. Well, maybe what we should start off is just make sure that people realize that there is a difference between what's called investment-grade bonds and high-yield bonds, also known as junk bonds. So, those bonds that are high-yield, or junk, are rated below investment grade, so those would be BB+ or lower by the rating agencies. They do have higher default risk, higher credit risk than those investment-grade bonds, which are rated BBB- or better.

Now, we have seen corporate credit spreads widen this year. A lot of that is due to the situation and the conflict that we've seen in Ukraine and some of the global macroeconomic risks that we're seeing there. But I do think that investors are well paid for taking on that additional corporate credit risk today. Now, I still recommend staying in kind of that middle-duration area. Investment-grade bonds typically have longer duration profiles. So, I'd want to stick into those medium-duration funds and investment-grade. High-yield bonds typically have shorter maturities. They also have those higher yields, so that naturally keeps their duration risk a little bit lower than investment-grade. In the high-yield market, I think you're getting paid pretty well for the corporate credit risk you're taking today. A large part of that is because we have a differentiated view for economic growth this year. So, according to our U.S. economics team, we are looking at above-consensus economic growth not just this year but actually for the next three years compared to the rest of the Street.

In an environment where you do have rising economic growth, again, it will be slower than what we saw last year, but on a historical basis, it's still going to be relatively robust. That's going to keep defaults relatively low. It's going to keep downgrades relatively low. And in fact, in an environment like that, I would actually expect to see more upgrades than downgrades. All of that to me would bode well for high-yield bonds.

Dziubinski: Interesting. Let's pivot and talk a little bit about the stock market and stocks in general. Growth stocks for a part of this year have gotten smacked around a little bit, and that's due, I'm assuming, in part to the anticipation of rising interest rates. So, let's talk a little bit about growth stocks and value stocks in rising-rate environments in general.

Sekera: Just to make sure that everyone is kind of aware, we do a discounted cash flow model in order to come up with our valuations. So, essentially, we're projecting out how much cash we think a company is going to earn over its lifetime. We then discount that using a weighted average cost of capital to come up with our present value today. So, in that model, how much that interest rate is that you use to discount that is going to have a big impact on what you think that company is worth today.

Now, in the marketplace, we did see interest rates come down very substantially during the pandemic. They've risen off their lows. But I don't think the market and we ourselves never brought our risk-free rate in that weighted average cost of capital down to as far or as low as the market had gotten. So, I still think that, at this point, I think the selloff in growth stocks this year has really been much more to do with the valuation than it necessarily was to do with the rising interest rates that we've seen.

For example, I think growth stocks have bottomed out maybe about two weeks ago. Now, growth stocks have actually had a pretty good rebound since then. But over that exact same time period, interest rates have also been rising. So, we came into the year saying that we thought the market was broadly overvalued and specifically growth stocks were overvalued. We had a webinar recently on our views of what was going on with the Ukrainian conflict and how that was impacting markets, had noted at that point in time that growth stocks had actually fallen so far, they've gotten to the point that they were now hitting that kind of undervalued territory in our models. So, going forward, we still think that growth stocks are a little bit undervalued here, and we still think there's a lot of opportunities for investors there. We also still think that value stocks, which came into the year being slightly undervalued, they've actually held their own, I believe they're up 1% or 2% year to date, are also a good area for investors. The one area I'd still shy away from are what we call core stocks, so those stocks that have a blend of both growth characteristics and value characteristics. Generally, we think they're still a little bit overvalued today.

Dziubinski: Interesting. Let's talk a little bit about sectors. What might investors expect from a sector perspective when it comes to going into a rising-rate environment?

Sekera: Sure. As we talked about, growth stocks in a true rising-rate environment, certainly would have a lot of headwinds as far as their valuations as interest rates continue to rise. Based on my own modeling at this point, I do think interest rates can probably rise a good 50 to 75 basis points from here before we really start to see interest rates really impacting the present value of those stocks.

So, again, we think growth right now is slightly undervalued. Technology stocks also slightly undervalued, but those would be the ones that I'd be most concerned about later this year if we continue to see interest rates rise. If the 10-year, for example, really starts getting much closer to that 3% area, that's where I start thinking we see interest rates really impacting the valuation of those stocks.

Value stocks, again, I think they have good economic tailwinds behind them for later this year, and those are stocks where the value of those stocks is much more stable than growth stocks, because the valuation is going to be based on the earnings of that company over the next couple of years, whereas of course, growth stocks, the value of those stocks is how much those earnings are going to be in the future.

Dziubinski: So, bottom line, given where valuations are today, Dave, and as well as this backdrop of rising interest rates, hot inflation, maybe a little bit of uncertainty about the economy, where should investors, if they have some money to put into the market today, what do you think, what would you suggest?

Sekera: Well, based on the composite of all the equity analysts' fair values for those stocks that we cover that trade on U.S. exchanges, we do think the U.S. stock market, broadly speaking, is trading at a slight discount to our fair values after this market pullback. However, I would note that I still would urge caution for investors. I do think that there is still the potential for a lot more volatility in the marketplace with the ongoing conflict in Ukraine. And until that's resolved, I do think that we're going to see a lot of these large daily movements, both to the upside and the downside based on headlines coming out of there.

Now, when I look at the different sectors that we cover, the communications sector is by far the most undervalued sector in today's marketplace. And that's a combination of both, some of the large technology stocks that are really in the communications sector. So, when I'm looking at our valuations there, over half the sector index is composed of both Alphabet, the parent of Google, as well as Meta, the parent of Facebook. Those are two stocks that we both think are very significantly undervalued. But the communications sector also has a more traditional type of names in there that we see a lot of value for investors today. AT&T is one that we've talked about and written about in the past that we see a good catalyst for unlocking shareholder value there.

The next most undervalued sector is going to be consumer cyclical. And I think the theme there that we're really looking for is, economic normalization in the second half of this year, and as the pandemic continues to recede, you're looking at consumer behavior shifting back toward prepandemic types of spending patterns, going back into the services spending away from goods spending. And as I think about that, looking at those sectors specifically that had been under a lot of pressure during the pandemic, getting a lot of that business back over the course of the second half of this year and into next year.

Now, the one thing I would caution investors is that we've been big proponents of the energy sector for about two years now, and that was really the sector that we had thought was the most undervalued. Now, it rose, I think, 55% according to our index last year. It's over 30% return this year. So, after those runs, we now think that energy is fully valued and in a number of cases actually starting to get to be overvalued as well. So, I'd just note for investors, after those kinds of returns, you might actually see that your portfolio is going to be overweight in the energy sector right now. So, I would actually think that now is probably a pretty good time to look to move back to more of a market-weight position in energy from where you might otherwise be.

Dziubinski: Well, Dave, thank you so much for your perspective today and for these investment ideas. We appreciate it.

I'm Susan Dziubinski with Morningstar. Thanks for tuning in.