Investor Spotlight: Surging interest rates drive global markets into bear territory

As rising interest rates curtail valuations, the stock market is witnessing a differential impact. Tech shares are defying the odds, soaring to new heights amidst a rally, while cyclical stocks bear the brunt of falling demand and higher borrowing costs.

This week on Investor Spotlight, we explore bear markets and how savvy stock picking has emerged as a key strategy in navigating this evolving market scenario.

Bear markets and their characteristics

The macroeconomic backdrop to a bear market Bear markets are characterised by low trading volumes and typically a 20% fall in share prices, but sometimes too much emphasis is placed on the technical explanations.

Historical context and current economic climate

Many commentators consider Australia and parts of the US are trading in bear markets, brought on by the steepest and fastest interest rate rises since the early 1980s, when then Federal Reserve Chairman, Paul Volcker was charged with eliminating double-digit inflation in the US economy.

Volcker induced two back-to-back recessions and quashed both demand and inflation.

Whilst the current economic environment is not directly comparable, there are striking similarities in terms of how inflation reached double digits, post two exogenous events – a global pandemic and the Russian invasion of Ukraine. The resulting lockdowns led to impediments on global supply chains including commodities, foodstuffs, consumer discretionary goods and staples.

At the same time, fiscal (government) payments and stimulus measures (zero interest rates) boosted savings and demand.

Central banks and the unwinding of stimulus measures

As central banks look to unwind all the stimulus and tackle sticky inflation, with supply chains largely repaired, much has been made of higher for longer interest rates.

There are, however, already signs that authorities have started to break the financial system, with US regional bank failures and a possible US recession just around the corner.

Impact of rising interest rates on different market sectors

Rising interest rates impact stocks. Markets are characterised by different sectors which have varying degrees of exposure to the economic cycles and thus levels of interest rates.

There are generally three baskets of stocks - those that are cyclical such as banks, commodities (resource stocks), industrials, consumer discretionary and transports. More defensive sectors such as consumer staples, healthcare companies and utilities. Then there is the technology sector which has both defensive and cyclical characteristics.

The cyclicals are most impacted by rising interest rates (falling demand) and slower economic growth; while defensives can ride through the cycle as the business models are generally less interest rate sensitive.

Some aspects of the technology sector are less cyclical and are exposed to secular growth trends, such as data centres and the latest buzz ‘AI’.

As a rule of thumb rising interest rates have a two-fold impact on the share market. In the first instance, higher rates reduce the valuations placed on shares, as the increased cost of capital makes shares less attractive to the investor. Bank deposit rates are now more appealing and less risky than shares.

Secondly, higher interest rates impact earnings to varying degrees. Cyclical companies are more impacted as the consumer reduces spending and property markets are hindered by higher borrowing costs.

A market of stocks, not a stock market

If we look at the ASX 200, the top two hundred shares in Australia by market capitalisation (valuation), the financials (banks, insurance companies) and the resource sector (mining – materials, energy, lithium, gold etc) represent some 50% of the index.

Most of these cyclical stocks are perceived as bell-weather barometers of economic growth and for overseas investors, global growth.

By comparison, the S&P 500, the top five hundred stocks in the US, have a hefty weighting to the world’s largest technology companies, Apple, Alphabet, Meta, Microsoft, Nvidia and Tesla. These stocks represent some 27% of the index.

As economist David Rosenberg quipped recently, technology stocks are in some cases reaching all-time high prices and taking the S&P 500 and Nasdaq index with them, while the cyclical – industrials, banks and transports are down minus 30%.

Looking at FNArena weekly data, the Australian Information Technology sector is trading 17.52% higher in the April to June 2023 quarter, versus Materials and Metals and Mining which are down by -6.1% and -7.1%, respectively.

In comparison, the ASX 200 is down -0.30% for the quarter, while Nasdaq and the S&P 500 are up 6.17% and 2.34%, respectively.

The impact of the rally in technology shares is more pronounced over the calendar year-to-date, where Nasdaq is up 23.97% and S&P 500 is up 9.53%. Australia by contrast is trailing, up only 1.65%. Within Nasdaq, big tech has led the charge, Nvidia is up over 100%, Microsoft is up 38%, Apple 35%, Meta - 118% and Alphabet - 41%.

Stock picking has been key in 2023

For select stocks and sectors, investors have been effectively making a montser in 2023.

Whether the tech rally can continue, will to a large part depend on where interest rates go from here. But as 2023 has shown, stock picking has to a large degree been the key to navigating what some commentators would classify as a bear market.