Will Rising Interest Rates Spell Disaster for Stocks? Not Automatically

In this piece, Russ Koesterich examines the possibility that equities might still experience growth in 2025 even with the likelihood of an elevated interest rate scenario.

Key Insights

• Traditionally, an increase in interest rates has tended to compress stock multiples, or valuations. However, this correlation is only substantial when rates shift dramatically by 3% or more.
• A moderate increase in rates, driven by stronger nominal growth, could actually bolster earnings.

Although equities may rise, the bond market's performance remains crucial. Elevated rates imply that the equity market may continue to favor companies that are less sensitive to interest rate fluctuations.

Equities concluded the year on a shaky note, despite another robust performance. For the first time since the late 1990s, stocks achieved two consecutive years of gains exceeding 20%. However, the year ended with investor unease due to persistent inflation and high long-term yields. In 2024, U.S. 10-year yields rose by approximately 0.60%, primarily due to a 0.50% increase in real rates. The question arises: Can stocks maintain their upward trajectory if interest rates continue to climb? My perspective is affirmative, provided that any rate increase remains moderate.

There are two main reasons why equities can withstand higher interest rates: the complex interplay between rates and stocks, and the fact that higher rates often coincide with more rapid economic expansion. Historically, higher rates have put downward pressure on stock multiples, but this effect has only been significant during extreme rate hikes. Small rate changes have typically had a minimal impact on valuations. It has been when real rates have reached peaks of around 3% or higher that stock valuations have frequently been adversely affected.

Beyond the level of rates, the reason for their increase is also important. If rates climb due to deficit spending concerns, markets could be in jeopardy. However, a modest rise driven by stronger nominal growth could support earnings. Assuming a nominal growth rate of 4.5% to 5.0%, earnings have the potential to exceed expectations. Even if valuations decline, stocks can still rise on the strength of robust earnings growth.

Monitor Hedges and Market Leaders

While equities may advance, the bond market's behavior remains significant. Two rate-related factors to monitor include the correlation between stocks and bonds and the influence of 'rate beta' on market leadership.

As stocks have continued to edge higher over the past two years, investors have had to reconsider their hedging strategies. As previously discussed, bonds have become less effective as a hedge. If investors are more concerned about rates than a recession, the correlation between stocks and bonds is likely to remain positive, turning long-term bonds into a risk factor rather than a risk management tool.

High rates also suggest that market leadership may continue to be dominated by a few mega-cap companies that are relatively indifferent to interest rate changes. This is because market segments most sensitive to interest rates remain vulnerable, including companies reliant on continuous capital raising, many small-cap firms, and dividend-focused stocks.

The converse of this is that many recent leaders will likely maintain their advantage. Apart from favorable long-term trends, many large tech and related companies are likely to continue benefiting from low debt, substantial cash reserves, and consistent earnings growth (refer to Chart 1).

Chart 1

Global Sector Earnings & Sales Growth

12-month forward earnings and sales growth estimates (MSCI World sectors)

Source: LSEG Datastream, MSCI, and BlackRock Investment Institute. Jan 06, 2025

Note: The bars represent the collective analyst earnings growth forecasts for global sectors. Dots represent sales growth estimates.

The Final Word for Investors

I would not advocate selling equities solely based on higher interest rates. Stocks, particularly the large ones that comprise U.S. indices, have the potential to demonstrate resilience due to their robust balance sheets and cash-flow momentum. However, interest rates will continue to play a role. Even slightly higher rates could lead to another year where market leadership is concentrated among a relatively small group of highly profitable, cash-rich companies.