Market’s Uneven Response to Higher Rates

Summary

In this article, Russ Koesterich discusses how tech strength is hiding broader market weakness, as higher rates begin to weigh on rate-sensitive sectors.

Key takeaways

• As rates grind higher, headline market resilience is masking significant weakness beneath the surface, with 10 of 11 sectors flat or negative in September. Market stability in this environment is being driven by a handful of tech and AI related stocks. 
• Rising yields are hurting the most rate-sensitive areas of the market, including small caps, consumer and housing related.
• Technology remains the market’s key support, with strong AI-driven earnings growth fueling semiconductor and large-cap tech performance. That said, many large tech companies are financing massive AI-related capital expeditors with debt, which may make them more sensitive to further increases in rates. 

It could have been worse. With yields approaching the highest level in 20 years, U.S. stocks appear to have taken higher rates in stride. Large cap U.S. equities were only slightly lower in September. However, the resilience was almost entirely due to strength in tech, and specifically semiconductor names, with the rest of the stock market struggling.

Resilience is mostly skin deep

I last discussed rates and equities back in August. At the time, I highlighted the non-linear relationship between stocks and bonds. While the level of rates and small changes tend to have little impact on stock’s performance, large abrupt moves have historically coincided with negative stocks returns.

Since early August, U.S. 10-year yields have risen by more than 0.65% and by roughly 1.35% since the March low. While focus has been on the inflationary impact of higher oil, higher rates have been almost entirely driven by higher real or inflation adjusted rates.

Curiously, large cap stock indices have barely moved thanks to a roughly 5% gain in the tech sector. Despite existential warnings from some quarters of the AI industry, investors have renewed their enthusiasm for AI related names, particularly semis and memory, on the back of surging earnings and the rollout of consumer-related agentic AI.

However, below the surface it has been a tough month: 10 of 11 equity sectors were flat or down in September. The worst damage was concentrated in the most rate sensitive sectors: consumer, utilities, housing and small caps. The Russell 2000 and the S&P 500 consumer discretionary sector both lost -9% versus their August highs. As typically happens, the worst carnage occurred in housing related stocks, with an index of U.S. homebuilders down approximately -16% from its summer peak.

What to avoid

While headline indices have managed to avoid a more significant decline, investors should still treat the move in rates as a major driver of stocks. To my mind, this suggests three strategies. First and foremost, consider bonds as a good source of income, not as a hedge. With stock-bond correlations at 25-year highs (see Chart 1), I’d avoid using long-term bonds as a tool to mitigate equity risk.

Chart 1
Correlation of bond and equity returns

From a sector perspective, the parts of the market that have been hit the hardest are exactly the ones you’d expect. To the extent rates remain elevated, continue to underweight consumer and housing related names, along with small caps.

Finally, the market has gotten by thanks to earnings gains in the tech sector. While strong earnings can continue to power these names, the sector is resilient, but not immune to higher rates. While the sector has historically been distinguished by high free-cash flow, select names, particularly the hyper-scalers, are now selling lots of bonds to finance a $1 trillion capex spending spree. In short, I believe the market can live and still move higher with a 5% 10-year U.S. Treasury yield. While not my base case, 6% would be tougher.

To obtain more information on the fund(s) including the Morningstar time period ratings and standardized average annual total returns as of the most recent calendar quarter and current month end, please click on the fund tile.
The Morningstar Rating^TM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure (excluding any applicable sales charges) that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.