- Interest rates look poised to stay higher for longer, and that's bad news for the stock market.
- According to JPMorgan, higher interest rates ultimately means less profits for corporations.
- These are the four reasons higher rates will keep downward pressure on stocks, according to JPMorgan.
All signs suggest interest rates will remain higher for longer as the Federal Reserve continues to hike interest rates in a bid to tame inflation.
That's bad news for the stock market, which has yet to fully come to terms that interest rates will stay high and even move higher from current levels, according to JPMorgan.
"The bond market has been increasingly pricing-in a more hawkish scenario, but the equity market less so, with relative equity valuation at the high end of the historical range," JPMorgan said in a Monday note. "History implies that for current level of real rates the S&P 500 multiple is ~2.5x overvalued."
The market currently expects the Fed Funds rate to surge another 100 basis points from current levels to about 5.4% by the end of this year. That expectation comes just a couple months after the market expected an interest rate cut from the Fed by the end of this year.
The current interest rate environment, combined with elevated valuations for stocks, spells trouble for stock prices in the coming weeks and months ahead, especially for small cap stocks.
"The risk-reward for equities is unattractive at current levels, particularly for small-caps that are disproportionately more sensitive to rising cost of capital," JPMorgan said.
These are the four reasons why stocks could come under pressure due to high interest rates.
1. Demand Destruction
Higher interest rates can lead to demand destruction for companies that are closely tied to consumer credit, such as housing, cars, and discretionary services. When interest rates rise, consumers' cost of ownership also rises, as such large purchases are typically funded with debt.
2. Lower Margins
Higher interest rates typically lead to softer profit margins and also coincide with weaker pricing power due to a consumer that might be on shaky ground.
3. Higher Interest Costs
Companies that own levered assets and rely on debt to fuel their business growth will have to deal with higher interest costs on that debt, and that can help erode profits.
4. Asset Write-Downs and Credit Losses
As interest rates remain high and consumers' financial outlook weakens, companies could be hit with credit losses, especially in the finance sector that offers consumer loans for cars and housing. JPMorgan highlighted that delinquency rates for sub-prime auto loans are starting to rise, and that's typically an early warning sign of a weakening consumer.
"Even though equities appear to be less concerned about the current restrictive policy environment, we believe the systematic risk is rising with every rate hike especially after ~15 years of global zero-rate policies," JPMorgan said.
Of particular concern, according to the bank, are the $4.5 trillion commercial real estate market and the $1.6 trillion leveraged loan market in the US. While those risks are not directly ties to large-cap US equities, any further deterioration of those market could spillover into other markets and spark contagion risk.