As a result of the Federal Reserve's decision last week to raise short-term interest rate targets by a quarter point to a range of 3.75% to 4%, today’s post must discuss two of the more boring financial topics: interest rates and inflation.
Kidding aside, it's important to note the Fed’s announcement included two key changes. One is now declaring, “Domestic spending has been resilient.” The other is that the rate hike, “Will support a timely return,” to the Fed's 2% inflation target.
Additionally, during his press conference, Chair Kevin Warsh emphasized the strength of the U.S. economy and the potential for an acceleration of that growth. In fact, it’s shifted the Fed's focus to price stability, with Warsh indicating inflation has been too high for too long.
In our opinion at Cornerstone, what's odd about these comments and the rate hike is that the Fed was making steady progress against inflation in the few years prior to the Iran war. Thus, the subsequent increase in inflation has been almost exclusively due to a spike in energy prices.
Historically, when inflation moved up temporarily due to a negative supply shock like we’re currently experiencing, the Fed would hold monetary policy steady until the supply shock ran its course. Yet now the Fed is hiking rates into a negative supply shock, even though higher short-term rates will do nothing to boost energy supply.
While last week's rate hike decision was expected, what was somewhat surprising was the dot plot released after the Fed meeting. It suggests policymakers will raise rates one more time later this year, with 12 members projecting one more hike of 25 basis points:
This development came as an immediate surprise to many. However, one positive is the median dot plot shows no rate hikes in 2027, and one rate cut in each of 2028 and 2029. This shows the Fed’s desire to have a less aggressive path for short-term rates than what’s currently embedded in futures markets.
We believe there’s a high likelihood this dot plot path plays out because the M2 measure of the money supply is only moderately growing. That signals that the year-ago comparison measures of inflation should settle down towards the 2% target once we get a little more than a year past the initial oil price shock.
The Economy is Strong
With that out of the way, we can turn our attention to interpreting what this means for investors moving forward. The hawkish shift arguably reflects the Fed's increased impatience about the battle against inflation, as was repeatedly expressed by Warsh.
Still, we can also deduce that it is also apparent that the voting members felt comfortable enough about the strength of the economy to allow themselves to indulge in said impatience. We can glean this attitude of optimism from Warsh's comments which made clear that he views the economy as having strengthened since the July meeting.
In a way, this can be interpreted as a bullish sign for stocks after any initial market shock volatility. The fact that the Fed decided its predominant focus should be on the price stability side of the dual mandate and not the labor market side is arguably a big vote of confidence. It suggests the central bank thinks the economy is strong enough to handle even a 50-basis-point increase this year.
Last Thursday's quick market rebound may reflect this interpretation after investors were able to fully digest the comments and details of the previous day’s decision. If so, it’s important because equity markets do not trade on interest rates in a vacuum, but on the reasons why those rates are moving.
When a yield increase is driven by strong economic expansion, history tells us stocks not only tolerate higher yields, but appreciate along with them. Interest rates rise for two primary reasons:
- Tightening monetary policy to combat inflation
- Expanding economic output
So, Warsh’s emphasis on a strengthening economy begins to paint a more positive picture than many initially thought. And it’s easier to believe when we realize the current real U.S. gross domestic product is currently running at a strong 4.4% pace for the third quarter:
When combined with a baseline inflation rate of around 2.5%, projected nominal GDP growth reaches nearly 7%. This matters because if nominal GDP growth is greater than the 10-year Treasury yield, equity markets can remain constructively bullish. If nominal economic output expands at nearly 7%, companies can generate sufficient revenue expansion to absorb a 4.5% to 5% interest rate hurdle.
The Fundamental Foundation
Historically, as long as sales growth exceeds the risk-free rate, corporate profit margins remain durable. Currently, this is the case as Q3 2026 revenue growth for the S&P 500 is projected to be 11.9%:
Once again, the most important fundamental foundation in determining the strength and support for the equity markets is earnings, earnings, earnings. We've already had two record-breaking quarterly earnings seasons, and the current estimated Q3 year-over-year earnings growth rate for the S&P 500 is 28.7%:
If that happens, it will mark the third consecutive quarter of earnings growth above 25%.
Such growth reflects the economic strength dynamic Warsh mentioned multiple times in his press conference. It’s lowered the forward 12-month price-earnings ratio for the S&P 500 to 19.1 – well below the five-year average of 19.8:
Earnings are the key engine for stock prices. When combined with P/E ratio contraction, we can see a fundamental foundation for positive returns moving forward. A strong GDP ensures corporate earnings remain on solid footing.
Importantly, the counter argument is higher yields will create a significant interest expense burden on corporate debt. However, over 75% of S&P 500 corporate debt is now structured in long-term, low-coupon fixed rate maturities.
These data points support an environment where equity markets can perform well in a 4%-5% yield regime because of the healthy, non-recessionary economic landscape. Similar economic landscapes provided the necessary support for positive forward equity returns after an initial Fed rate hike:
Also, we can be confident with returns when the Fed initiates a slow rate hike environment. This is why the new dot plot released last week becomes exceptionally important for the continued “bull” case – it shows clear intent by the Fed to raise rates slowly into economic strength.
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