Higher interest rates and rising costs are a bad brew for stocks

  • Stocks are facing the double headwinds of rising interest rates and rising input costs, which could slow down earnings growth and pressure margins.
  • The 10-year Treasury yield touched 3 percent for the first time in four years, a wakeup call to investors that interest rates are continuing to move higher.
  • Investors have been dumping stocks that miss on margins or offer disappointing outlooks even if earnings are good. Caterpillar was a poster child for that trade on Tuesday.

Rising costs and rising interest rates make for a bad brew for stocks.

The 10-year Treasury yield rose to 3 percent Tuesday for the first time in four years. The psychologically important number sent ripples across financial markets because rising interest rates are a sea change for consumers and companies that have lived with ultra-low borrowing costs for the past decade.

Along with interest rates, other costs are rising for companies, with the potential to bite into profits and dampen earnings growth.

This earnings season, with double-digit growth, was expected to pump up stock prices and take investors' minds off trade wars and geopolitical concerns. But strong earnings may have opened the door to a new concern — commodities and labor costs are going up along with interest rates.

"The reaction to earnings has been lackluster even though we are reporting great numbers," said Art Hogan, chief market strategist at B. Riley FBR. But Hogan said companies are talking about a new issue, and some of it may be a result of tariffs and threats of tariffs. "We are clearly hearing caution about input costs, whether they be wages, commodity based, interest rates, whatever. All of that comes with no economic benefit," he said.

Caterpillar was a case in point. Shares of the industrial equipment maker soared in early trading Tuesday on good earnings, but swooned later in the day and fell 6 percent lower after CFO Bradley Halverson told investors that the first quarter was likely the "high watermark" for the year. Operating margins will be strong but not as strong in the next few quarters, he noted.

In a slide presentation, the company said it sees pricing improvement, but that is partially offset by higher material costs.

The big technology stocks known as FANG were also crushed on Tuesday, with Alphabet leading the sell-off. The parent of Google was slammed after analysts warned it could be less profitable because of increased spending.

Overall, stocks fell sharply, with the Dow down 424 points at 24,024. The S&P 500 fell 1.3 percent to 2,634, and the Nasdaq was off 1.7 percent, at 7,007.

Lori Calvasina, RBC's chief U.S. equities strategist, said margins were so much a concern that earlier this month she cut her S&P 500 target for year-end to 2,890 from 3,000. She now expects margins will be flat this year, not as expansive as she previously thought. She cut earnings-per-share expectations for the S&P 500 to $151 from $155.

"The market can still go up, just not as much as we thought at the beginning of the year," she said. "We think people need to temper their enthusiasm a little bit."

She added that she got concerned about the effect of higher wages, which she heard companies discussing on fourth-quarter earnings conference calls.

"I still like the market on a six- to 12-month view. We still like the market from here," she said, adding it could continue to chop around.

"The question is, is there still value in stocks in an environment where maybe margins are not as high as they have been recently, near record highs?" said Ed Keon, chief investment strategist at QMA. "The good side of having stocks being roughly flat and earnings be up a lot is that the valuations now look more reasonable than a short time ago."

Despite the rough patch, Keon says the market still looks set to go higher. "I still think when the end of the year comes, it will be earnings that drove the market higher. ... Sometimes a rose really is a rose," he said.

The other issue hanging over the market is the fear that inflation will push the Fed to hike interest rates more than the two remaining hikes it now forecasts for this year. A rising 10-year yield affects rates across a broad spectrum of consumer and business loans, even though 3 percent is still low by long-term standards.

"I don't know why 3 percent on the 10-year freaks people out so much, but it is certainly something the market got in its head," Calvasina said. "Three percent should not be the point of pain, but it's something I hear from investors." The 10-year briefly touched 3 percent Tuesday morning before drifting slightly lower.

The 10-year is the benchmark U.S. sovereign, the most influential in the world, and in the U.S. it is the yield that is most closely tied to home mortgages. Overall, Treasury yields also influence rates on the $26 trillion in U.S. corporate, municipal, mortgage and agency debt outstanding, according to data from the Securities Industry and Financial Markets Association.

"I think it woke up the equity geeks and now they're worried about an accelerating Fed, and that's scaring the market," said Andrew Brenner of National Alliance. As the 10-year touched 3 percent and backed off Tuesday, the difference in rates on investment grade bonds and high-yield corporate debt was barely changed.

There are a number of ways higher rates can interfere with stock market gains. Besides making borrowing more expensive, rising interest rates could slow down the record amounts of corporate debt being used to fund stock buybacks. Higher borrowing costs can also make some projects less financially feasible, and that can ultimately slow down the economy as interest rates keep rising.

Higher rates could also make bonds a more enticing investment than stocks, especially for pension funds and foreign institutions.

"I think everyone can accept the idea that most rates are linked to Treasurys in one way or the other. What this means from a macro standpoint is the cost of money is getting much more expensive for a society that's very levered and a country that's very levered. Our cost of doing business is going to get more onerous," said George Goncalves, head of rate strategy at Nomura.

Ralph Axel, director of U.S. interest rate strategy at Bank of America Merrill Lynch, said corporate debt issuance is down about 4.8 percent this year as yields have moved higher. Also down are the amount of mortgage debt being issued, with $411 billion issued through March, $50 billion less than the same time last year.

"There's a very big debate whether we have more room to run in the expansion, and higher rates and inflation and higher growth, or is this going to be the time to buy? Is there going to be a wall of money that comes in when we get to 3 percent to take the other side," he said. Bond yields move opposite price, and yields rise when investors are selling.

Axel said he expects the 10-year to reach 3.25 percent by the end of the year, and that's a level where some strategists see stocks running into trouble.

"There's no doubt it's going to bring in some buyers [into bonds]. It's an interesting number to say 3 versus 2.99, but it's still very low. The issue here is rates are extremely low by longer-term historical standards," said Axel.

WATCH: US 10-year at 3% then and now