- Growth stocks struggled in 2022 when the Fed started raising interest rates. But in 2023, rates have continued to go up, and growth stocks have done phenomenally well.
- Another piece of investment advice that’s been challenged this year is the idea that rising interest rates are good for banks.
- Dividend stocks did well last year as the Fed was starting to increase interest rates, but it hasn’t been fun being a dividend stock investor in 2023.
- In 2022, investors learned the hard way that bonds don’t always cushion stock market losses.
Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. As 2023 winds down and investors look back at the past 12 to 18 months in the market, they’re finding that some of the conventional wisdom about investing was tested. Joining me today to talk about some investment truisms that have been challenged during the period and what investors can take away from the experience is Dan Lefkovitz. Dan is a strategist with Morningstar’s indexes team.
Great to see you, Dan.
Dan Lefkovitz: Thanks, Susan. Great to be with you.
Do Higher Interest Rates Hurt Growth Stocks?
Dziubinski: The first piece of conventional wisdom that’s been upended this year in particular is that higher interest rates hurt growth stocks. Let’s start out, tell viewers about why that is a piece of conventional wisdom, why would higher interest rates hurt growth stocks.
Lefkovitz: It has to do with how stocks are valued. So, higher interest rates decrease the worth of future cash flows. And because growth stocks, their cash flows are further out into the future than value stocks, higher interest rates are supposed to have a disproportionate impact on them. That’s a theory at least.
Dziubinski: Then let’s talk about the reality of 2023. Now, growth stocks did struggle in 2022 and that is in fairness when the Fed started raising interest rates. But it’s been a whole different story in 2023. Rates have continued to go up, and growth stocks have just in general done phenomenally well. So, what happened?
Lefkovitz: Starting in March 2022, we had seven interest-rate hikes by the Federal Reserve in the U.S. trying to combat inflation. And sure enough, our broad U.S. growth stock Index fell 32%. Our value stock Index was down only 7%. So, it seemed that interest rates were to blame for growth stocks suffering. And this was repeated so often that it, sort of, became generally accepted. But if you look at the historical record, it’s actually pretty mixed when it comes to interest-rate hikes and its effect on stocks and its effect on style leadership. So, if you look at the 2015 to 2018 period, we saw a number of interest-rate hikes then; the Fed was normalizing after zero-interest-rate policy for many years post-financial crisis. Growth stocks outperformed during that stretch. It was the FANG era, the FANG being the acronym for Facebook, Amazon, Netflix, and Google—growth stocks that were leading the market during that time. Here we are in 2023. There have been further interest-rate hikes. And we’re still talking about a small clique of growth stocks—it’s now called the Magnificent Seven—that’s leading the market. They’re responsible for the lion’s share of equity market gains in 2023, despite interest rates continuing to climb. So, you’re hearing a lot less about interest rates hurting growth stocks this year.
Are Rising Interest Rates Good for Banks?
Dziubinski: Now another piece of investment advice that’s been challenged this year is the idea that rising interest rates are good for banks. So, why in theory would that be the case?
Lefkovitz: There’s the old joke about the banker’s jobs, Susan, that you can probably remember—3-6-3. So, the banker pays 3% to depositors, collects 6% on the money it lends, and then is on the golf course by 3 o’clock. I’m going to get all kinds of hate mail from hardworking bankers out there. But when rates go up, it increases the spread between the deposit rates and the lending rates because the bank raises lending rates more rapidly. So, that’s the theory. Interest rates you hear very commonly are good for banks.
Dziubinski: But it hasn’t been great for bank stocks this year. What’s happened?
Lefkovitz: This has been a really tough year for banks. Our industry index that tracks regional banks in the U.S. is down almost 30% this year. We had a number of failures earlier this year—Silicon Valley Bank, Signature Bank, First Republic. And it raised my eyebrows when higher interest rates were named as one of the culprits for the bank failures. It turns out that Silicon Valley Bank, to take one example, had a lot of long-dated Treasury bonds on its balance sheet, and those tanked when interest rates were jacked up last year. So, it really depends on the bank’s exposure and its business model. It’s not always the case that interest-rate hikes are a good thing for banks.
Rising Interest Rates and Dividend Stocks
Dziubinski: Right. It’s dragged a lot of them down this year, even if they didn’t have that exposure. So, another piece of conventional wisdom related to interest rates is that rising rates are bad for dividend-paying stocks. Now, first, explain why that’s often seen as the case.
Lefkovitz: I learned this as a beginning analyst that rising interest rates are like kryptonite for dividend payers because they make cash and fixed-income instruments, they raise the yields on those, less volatile instruments, and they make them more attractive from an income perspective relative to dividends, which are equities and more volatile. Rising interest rates also raise the debt-service burden for a lot of companies and the dividend-rich sections of the market. So, that’s the theory.
Dziubinski: And we’ve seen something again, sort of like the growth stocks: one thing one year, one thing the next year. So, dividend stocks actually did really well last year as the Fed was starting to increase interest rates. And boy, it hasn’t been fun being a dividend stock investor in 2023.
Lefkovitz: That’s absolutely right. Last year, the yield on our core bond index went from 1.7% at the start of 2022 to 4.5% at the end. So, just a really dramatic spike in yields. And yet, our dividend indexes, some of them were actually in positive territory last year, even as the overall equity market was down. So, that was a head-scratcher. I don’t think it had anything to do with interest rates. I think it was the fact that the dividends, a lot of dividend-rich areas, did well last year, like energy was the best-performing equity sector, more defensive areas like healthcare and utilities and consumer staples lost a lot less than technology and the growth areas of the market that we talked about earlier.
Dziubinski: And then this year?
Lefkovitz: This has been a struggle for dividend payers. As you’ve covered, Susan, it’s been a narrow market this year, led by the Magnificent Seven and by growth stocks and the theme of artificial intelligence. It hasn’t been a disaster for dividend payers, but it hasn’t been a particularly good year.
Bonds Don’t Always Cushion Stock Market Losses
Dziubinski: Then of course in 2022—we’ll go back a little bit before 2023 here—investors learned the hard way that no, bonds don’t always cushion stock market losses. Let’s go through a little bit of what happened in 2022.
Lefkovitz: This was a real surprise for investors that were accustomed to seeing high-quality bonds hold up really well in bear markets for equities. The three previous bear markets for equities, our Morningstar US Core Bond Index was positive, even as the broad equity market was down over 20%. That would include the first quarter of 2020, the onset of the pandemic, the financial crisis of ‘08, and then the early 2000s after the dot-com bubble burst. Last year, both stocks and bonds really took it on the chin. Our Multi Asset Index was down about 16%. That’s the 60-40 version. We heard a lot about the death of 60-40, the death of diversification. This year, it’s back. Bonds are down slightly, and stocks are up. So, they are moving in separate directions this year.
Should Investors Ignore Conventional Wisdom?
Dziubinski: Let’s take a step back. What’s an investor supposed to do, Dan? Ignore this conventional wisdom when it comes to investing? Or are you supposed to be building a portfolio that’s not only for the unexpected but for the unconventional? What do we do?
Lefkovitz: I mean, I think you have to be really skeptical of a lot of these rules of thumb. There’s less certainty, there’s less predictability in investing than we’d like to think. When it comes to the way that assets interact, the forces that move markets, which investments best suit the macro environment. We don’t have the immutable laws of physics in investing. So, what’s an investor to do? I mean, far be it for me to give investment advice, but I think there’s a lot of merit to just building a strategic asset allocation and sticking with it through thick and thin, rebalancing periodically. Our Mind the Gap study at Morningstar shows the cost of investors mistiming their entry and exit points, trying to get cute with tactical allocations, trying to time the macro environment and making bets on interest rates.
I think another approach with a lot of merit is to use valuation, just be really long-term about it. A lot of the rotations that we have talked about here today can be explained with valuation. Our equity research team, they called a lot of these things. Going into 2022, they said that tech stocks were overvalued, then they crashed. They said tech stocks were undervalued coming into 2023, and they’ve rebounded. It doesn’t always happen that quickly. So, the big caveat with valuation is that you have to be long-term and be patient because it can take time for price and intrinsic value to converge.
Dziubinski: Well, Dan, it’s great to see you. Thank you for your time. And maybe we’ll get back together this time next year and talk about what conventional wisdom in 2024 just didn’t sort of pan out.
Lefkovitz: There will be more surprises. We can be sure about that.
Dziubinski: That’s right. Good to see you. Thank you.
Lefkovitz: You too.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
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