Here’s what a prolonged rally means for the stock market

The S&P 500 index is up 7.4% this year and is down just 2.5% from its all-time high set on March 28th. Stocks have been rising since the 10-year Treasury yield peaked at 5% in late October. This also fueled an “all-around rally”, pushing up the prices of other asset classes from gold to bonds.

But some investors are starting to worry that future stock market gains will be more difficult. Wednesday’s higher-than-expected inflation report raised questions about whether the Fed can cut interest rates this year without signs of an economic slowdown. Earlier this year, Wall Street announced six or even seven rate cuts by 2024, and now some investors are beginning to doubt that the Fed will cut rates at all.

That could cause problems for the stock price. The benchmark 10-year U.S. Treasury yield posted its biggest single-day increase since 2022 on Wednesday, ending the week at 4.499%.

Higher yields make stocks less attractive than holding U.S. Treasuries to maturity and raise borrowing costs across the economy, from corporate bonds to mortgages and auto loans.

“The calculus changes,” said Quincy Crosby, chief global strategist at LPL Financial. “There has to be a readjustment, there has to be an adjustment, and the interest rate regime has to be in line with the valuation situation.”

Below are some areas of the stock market that are susceptible to rising interest rates.

small hat

The S&P 600 index, which is dominated by small-cap stocks, fell 3% last week. That included a 2.9% drop on Wednesday after the inflation report, the biggest one-day drop since February. Small-cap stocks tend to derive most of their earnings from within the United States and are particularly sensitive to the trajectory of the economy.

One big reason is that small-cap stocks typically spend a much higher percentage of their operating income covering debt interest than large-cap stocks. The ratio of operating income to interest expense among S&P 600 stocks was 2.3 times as of March, according to Dow Jones Market Data. This compares to 7.6x that of S&P 500 companies.

They generally issue more floating rate bonds than larger companies, so their loan payments fluctuate with the benchmark interest rate. Rising interest rates mean higher interest expenses, which puts pressure on profits and increases the risk of default.

About 44% of corporate debt in the Russell 2000 Index, another small-cap index, had floating rates at the end of last year, compared to the S&P 500, according to data from Lazard Asset Management. It was 10%.

About 40% of companies in the Russell 2000 did not make a profit in the past year, compared with 10% of companies in the S&P 500, according to JPMorgan Asset Management.

big tech

Tech stocks have led the market rally since early 2023, driven by growing investor enthusiasm for artificial intelligence technology. Large companies have strong balance sheets and large amounts of cash, which should insulate them from the effects of rising interest rates. But some investors worry that popularity could start working against them if sentiment deteriorates.

The S&P 500’s information technology sector accounts for nearly 30% of the market-cap weighted index, more than twice the size of the other 10 sectors. When investors decide to book profits, it makes sense to turn to tech stocks.

“If you look at all the actively managed mutual funds and cap-weighted index funds out there, they’re all the same thing. Are Microsoft and Nvidia your biggest holdings? Is it Amazon?” Soundview Wealth Advisors said Emerson Hamm III, senior partner. “If there’s a vicious cycle in the market, that could cause problems for large-cap tech stocks.”When the Fed began its rate-hike campaign in 2022, the tech sector ended the year down 30%, with stocks like Amazon.com and The consumer staples sector, home to Tesla and others, fell nearly 40%.

cyclical

Cyclical stocks that are sensitive to economic trends, such as utility stocks, consumer staples stocks, and industrial stocks, become less attractive when interest rates rise, especially as they tend to be seen as dividend-oriented stocks.

The S&P 500 utilities sector has a dividend yield of 3.4%, consumer staples has a dividend yield of 2.4%, and industrial sector has a dividend yield of 1.4%. All of this seems paltry compared to his 4.5% risk-free rate on government bonds. Moreover, stocks do not offer enough additional yield to offset the risk of a slowdown in business activity due to rising interest rates.

Industrial conglomerate 3M has a dividend yield of 6.6%, but its stock price is down 0.1% this year. Consumer staples company Walgreens Boots Alliance has a yield of 5.6%, with its stock down about 30%. American Electric Power paid 4.3%, and its stock rose 1.1%. All three stocks are underperforming the S&P 500.

About 40 stocks in the S&P 500 index have higher dividend yields than 10-year Treasury bills, according to FactSet. Two years ago, when the Fed was just beginning its campaign to raise interest rates, there were 94 stocks offering higher yields.

Bank

Rising interest rates are causing depositors to move their money into treasuries and money market funds in search of higher returns, contributing to a decline in bank deposits. Meanwhile, banks are having to pay more interest to depositors looking for yield, hurting profits, especially for small and medium-sized banks. Wells Fargo on Friday said it expects its net interest income, or profit on loans, to decline 7% to 9% in 2024.

If interest rates remain high, delinquency rates may rise, leading to an increase in banks’ loan losses.

Rising interest rates have also pushed mortgage rates towards 7%, the highest level since December. This has left many prospective home buyers on the sidelines, leading to a sharp decline in mortgage transactions for major banks, which are their source of income.

The S&P 500’s real estate sector is down 7.2% this year, making it the worst performing of the 11 segments and the only one in the red.

Changes in interest rates are hitting smaller banks harder than big banks. The KBW Nasdaq Bank Index, which includes leading companies such as JPMorgan, has risen 2.1% since the beginning of the year, while the index of regional bank stocks has fallen 13%.

energy

Stock prices of oil and gas companies have risen further since they were among the top performers in 2022. Rising oil prices are boosting profits for oil and gas suppliers, while the sector’s largest companies are trading at a discount to the broader market. Exxon and Chevron trade at about 13 times and 12 times earnings, respectively, over the past 12 months. The S&P 500 trades at about 20x.

The S&P 500’s energy sector is up nearly 10% over the past month, outperforming every other sector in the composite index by at least 3 percentage points.

Email Hardika Singh (hardika.singh@wsj.com) and Charley Grant (charles.grant@wsj.com).