How will higher interest rates affect stocks?
It's getting real.
Stocks were hit Tuesday as investors begin to realize the main dynamics supporting equities over the last few years -- ultra-cheap dollars from the Fed, unstoppable corporate profits, and nonexistent volatility -- are at risk.
All are jeopardized by the growing likelihood that the Federal Reserve -- for the first time since 2006 -- responds to a fast tightening job market by raising interest rates as soon as June.
The Dow Jones Industrial Average lost 1.8 percent to close at 17,662 while the S&P 500 lost 1.7 percent to close at 2,044.
The catalyst was another strong reading on the U.S. jobs market: This time, from a Labor Department report that showed the number of job openings in January surged to 4.998 million, the highest in 14 years. The report built on last week's February payrolls report that had the unemployment rate dropping to 5.5 percent.
As a result, the U.S. dollar surged as currency traders responded to the specter of a more hawkish Fed compared to a European Central Bank that is starting its own stimulus program and a Bank of Japan that continues to aggressively print yen.
With the greenback at levels not seen since 2003 -- up 25 percent from its early 2014 lows -- commodities are getting hit (pushing oil down again), the euro is being hammered (pinching popular euro-yen carry trades), and emerging-market stocks are taking it on the chin (on capital outflows and a reliance on cheap dollar funding).
Over the last few years, things have depended on the smooth flow of cheap dollars from the Fed and a lack of cross-asset volatility. That's changing now as the Fed prepares to hike, undermining the calm the bulls have enjoyed since late 2012.
Moreover, a stronger dollar, weaker commodity prices (especially oil), and turbulence overseas all threaten the value of foreign profits earned by U.S. corporations -- threatening earnings growth which is already rolling over at a pace that's associated with recessions. In fact, the last time the dollar strengthened to this extent was in the midst of the last two recessions.
Let's also not forget that a big driver of corporate earnings growth in the last few years has been the loose labor market and a lack of wage inflation. With the latest data corroborating the solid February payrolls report, that's changing as well.
All this is coming at a time when stock valuations are expensive. Deutsche Bank strategist David Bianco notes that the S&P 500's price-to-earnings multiples are about 10 to 15 percent above historical norms. While stocks could still march higher from here -- after dealing with some near-term turbulence -- future gains would be limited to around 5 percent annually and depend on long-term interest rates not exceeding 3 percent from 2.1 percent now.
He sees a risk of a stock market drop of as much as 9 percent -- which would put the mid-October lows back in play -- as ongoing gains in the job market force the Fed to act, further boosts the dollar, and results in additional cuts to earnings growth.
