Stocks & Bonds Trade Lower as Interest Rates Continue to Rise

Monthly Client Update | November 1, 2023

Monthly Market Summary

  • The S&P 500 Index declined -2.2% in October but outperformed the Russell 2000 Index’s -6.9% decline. The Utility sector was the top-performing S&P 500 sector, while Energy and Consumer Discretionary led to the downside.
  • Corporate investment-grade bonds produced a -2.4% total return in October, underperforming corporate high-yield bonds’ -1.0% total return.
  • International stocks underperformed U.S. stocks. The MSCI EAFE Index of developed market stocks declined -2.9% and slightly outperformed the MSCI Emerging Market Index’s -3.3% return.

Stocks Decline for a Third Month as Rates Reach Highest Levels Since 2007

The S&P 500 gained more than 20% through the end of July but has since declined 8.3% over the past three months, bringing its year-to-date gain to 10.6%. A significant factor behind the recent equity market sell-off has been the sharp rise in interest rates, with the 10-year U.S. Treasury yield climbing +1.25% from mid-July through mid-October and rising above 5% for the first time since 2007. This surge in Treasury yields continues to weigh on both stocks and bonds as valuations adjust to a world of higher interest rates. Small-cap stocks underperformed large-cap stocks by over -4.5% in October, and defensive sectors outperformed cyclical sectors. In the credit market, bonds posted another month of negative returns. The following paragraphs discuss why stocks and bonds tend to experience pressure during rising rate periods.

Why Rising Interest Rates Cause Bonds & Stocks to Trade Lower

Consider two bonds: Bond A was issued one year ago and pays a fixed 2% interest rate, and Bond B was issued one month ago and pays a fixed 2.5% interest rate. On an annual basis, Bond A yields $2 per $100 of principal, while Bond B yields $2.50 per $100 of principal. Assuming all else is equal, a rational investor would choose Bond B because of its higher yield. To attract investors to buy Bond A and align its yield with Bond B’s 2.5% yield, the market will adjust the price of Bond A lower. In our example, the price of Bond A will decline so that its fixed $2 interest payment corresponds to a 2.5% yield. At this adjusted price, investors would earn a 2.5% yield with Bond A, making them indifferent to choosing between Bond A and Bond B.

Rising interest rates also cause stocks to trade lower. As interest rates climb, bonds offer a higher expected return, which makes bonds more competitive with stocks. The higher expected return on bonds can prompt investors to sell stocks and buy bonds, causing stock prices to decline. In addition, higher interest rates increase borrowing costs, which can slow economic growth and reduce corporate profits. If investors expect slower earnings growth, stock prices may decline as investors seek lower valuations to offset the heightened earnings risk.

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Annualized Return: The rate at which an investment grows each year over the period to arrive at the final valuation.
Bear Market: A decline of at least 20% from the market’s high point to its low.
Beta: A measure of how an individual asset moves when the overall stock market increases or decreases.
Correlation: A measure of the extent to which two variables are related.
Dividend Yield: The dividend yield or dividend-price ratio of a share is the dividend per share, divided by the price per share. It is also a company’s total annual dividend
payments divided by its market capitalization, assuming the number of sharesis constant.
Developed Markets: A country that is most developed in terms of its economy and capital markets. The country must be high income, but this also includes openness
to foreign ownership, ease of capital movement, and efficiency of market institutions.
Emerging Markets: A country that has some characteristics of a developed market but does not fully meet its standards. This includes markets that may become
developed marketsin the future or were in the past.
GrowthFactor Stocks: Growth stocks are companies expected to grow sales and earnings at a fasterrate than the market average.
LargeCap Stocks: Shares of publicly traded corporationswith a market capitalization of $10 billion or more.
LTM: An acronymfor”Last Twelve Months”or the past one year.
NTM:An acronymfor”Next Twelve Months” or the next one year.
Price Return: The rate of return on an investment portfolio, where the return measure takes into account only the capital appreciation of the portfolio, not including
income generated in the form of interest or dividends.
Total Return: Return on a portfolio of investmentsincluding capital appreciation and income received on the portfolio.
Small Cap Stocks: Small-cap stocks are shares of companieswith a market capitalization of less than $2 billion.
Standard Deviation: In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates the
valuestend to be close to the historical average of the data set, while a high standarddeviationindicatesthe current value is outside of the historical average range.
Value Factor Stocks: Stocksthat are inexpensive relative to the broad market based on measures of fundamental value (e.g., price to earnings or price to book).

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