January’s blockbuster US labor market report has boosted the case for a longer run of interest rate hikes, with several Fed officials saying rates will have to climb to a higher peak than previously thought to bring down inflation.

But that may not spell a repeat tumble for stocks: the marginal impact on stock valuations of a one percentage point increase in rates is far less when you’re starting at today’s levels of around 5%, compared to what it is when you start from zero.

The bigger worry now is how long rates will remain high, impacting the real economy and, ultimately, corporate profits – especially considering that earnings estimates for the second half of this year are quite optimistic.

January’s blockbuster US labor market report has boosted the case for a longer run of interest rate hikes, with several Fed officials saying rates will have to climb to a higher peak than previously thought to bring down inflation.

But that may not spell a repeat tumble for stocks: the marginal impact on stock valuations of a one percentage point increase in rates is far less when you’re starting at today’s levels of around 5%, compared to what it is when you start from zero.

The bigger worry now is how long rates will remain high, impacting the real economy and, ultimately, corporate profits – especially considering that earnings estimates for the second half of this year are quite optimistic.

January’s blockbuster US labor market report has boosted the case for more interest rate hikes, with several Federal Reserve (Fed) officials saying rates will have to climb to a higher peak than previously thought. Some traders have even started placing big bets on rates going to 6% by September – more than a full percentage point higher than today’s levels. But despite all that, US stocks have stayed virtually flat since the jobs report came out. What gives?

Yes – and no. Early last year when interest rates were at virtually zero percent, the prospect of higher rates played a big role in sending stocks into freefall. But today, with rates already quite elevated at roughly 5%, the prospect of them going even higher isn’t as intimidating. That’s because the marginal impact of a one percentage point increase in rates is far less when you’re starting at 5%, compared to what it is when you start from zero. Put differently, rates rising from 0% to 1% hits stock valuations way harder than rates going from 5% to 6%.

Let me illustrate this with a simplified example.

Picture a hypothetical company that’s expected to pay a dividend of $100 per share next year, with this dividend expected to grow at a rate of 2% per year until perpetuity. To assess how changing interest rates would impact this stock’s valuation, we can use the Gordon Growth Model (GGM), which calculates a stock’s value as the sum of all of its steadily growing future dividend payments, discounted back to its present value. Here’s the formula:

We know next year’s dividend ($100) and its growth rate (2%). The discount rate can be determined using the Capital Asset Pricing Model (CAPM). Put simply, the CAPM states that a stock’s discount rate is equal to the risk-free rate plus an additional return required to compensate the investor for the extra risk associated with investing in the stock market. That latter component is adjusted for how the particular stock moves in relation to the overall market. Here’s the CAPM formula:

We can use the Fed’s level of interest rates as the risk-free rate. The historical market risk premium is how much the stock market overall tends to deliver above the risk-free rate. In the US, this has averaged around 6%.

Beta, meanwhile, measures how the stock moves relative to the wider market. A beta of one means the stock moves roughly in line with the market. For ease, we’ll assume our hypothetical stock has a beta of one, which is the case for the average stock in the market. That means our discount rate is simply the Fed’s level of interest rates plus six percentage points.

When interest rates are at zero, our discount rate is 6% and the GGM tells us that our hypothetical stock is worth $100 / (6% – 2%) = $2,500. If rates increase by one percentage point, then the stock’s value falls by a fifth to $100 / (7% – 2%) = $2,000.

Now let’s redo this exercise but start off with a higher level of interest rates. Today, rates are at roughly 5%. In that scenario, our stock is worth $100 / (11% – 2%) = $1,111. If rates increase by one percentage point, then the stock’s value falls by a tenth to $100 / (12% – 2%) = $1,000.

In other words: the rise in interest rates from zero to 1% caused our stock’s valuation to fall by 20%. But the rise from 5% to 6% caused it to only fall by half that amount (10%). This illustrates how the marginal impact of rate hikes on stock valuations decreases the higher rates are to begin with.

The GGM is a simplified approach to stock valuation, sure, but even if you use arguably more realistic approaches (like a 15-year discounted cash flow model), you’d still arrive at the same conclusion: the valuation impact of a one percentage point rate hike from 5% is roughly half what it is from zero percent. Finally, note that some investors use the yield on 10-year Treasuries as the risk-free rate and, if anything, that’s actually come down this year, implying *higher* stock valuations.

Last year, the Fed took interest rates from virtually zero to above 4%. And that was a big hit to stock valuations both because of the magnitude of the increase and because rates were starting off from a very low base (valuations were extra sensitive to hikes). Today, with rates already at roughly 5%, it matters less if they peak at 5.2% or 6%. You can also think of it this way: rate hikes are yesterday’s problem, and the bigger worry now is *how long* rates will remain high, impacting the real economy and, ultimately, corporate earnings.

Investors will get a better idea of the long-term outlook for rates in March when the Fed announces its next rate decision and releases its updated interest-rate projections – the central bank’s “dot plot”. The most recent dot plot (in December) showed that the Fed didn’t expect to cut interest rates until at least 2024. But that timeline will almost definitely be pushed back next month on the back of January’s exceptionally strong labor market report and hotter-than-expected inflation data. And the longer interest rates remain elevated, the more they’ll choke economic growth and corporate earnings.

And it could be that much of the market is just catching up to that reality. Even in the face of the highest interest rates in over 15 years, analysts have actually been quite slow to cut their forward earnings estimates. Many didn’t lower their estimates for the first half of this year until very late last year.

But while analysts have finally started adjusting to reality in the near term, they’re likely still too optimistic looking further out – evidenced by the relatively sanguine outlook for the fourth quarter of this year. In fact, for the third and fourth quarters of 2023, analysts are projecting earnings growth of 3.4% and 10.1%, respectively. That’s expected to offset declines for the first half of 2023, with analysts predicting overall earnings growth of 2.5% for the full year.

The big risk now is that those expectations prove way too optimistic as higher-for-longer interest rates stifle economic growth…

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