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Market optimism fades as higher interest rates signal a tough year ahead for investors

Natale Labia
By Natale Labia
14 Jan 2025
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In the first few weeks of the year, bullish sentiment about markets has fizzled faster than an overly ambitious New Year’s resolution, and the shift is perceptible in all corners of the market.

Well, that didn’t last long. Anyone hoping that the late 2024 festive cheer in markets would carry into January will be disappointed. In the first few weeks of the year, bullish sentiment has fizzled faster than an overly ambitious New Year’s resolution.

The shift is perceptible in all corners of the market. Take the most obvious indicator of sentiment  — equities. In the lead-up to the US elections, US stocks climbed haltingly, buoyed by the Federal Reserve’s first aggressive interest rate cuts in mid-September. Then came Donald Trump’s surprisingly decisive victory in November, which unleashed a wave of optimism. By early December, the S&P 500 had gained 6%, with sentiment-driven stocks like Tesla nearly doubling in value.

But the fun did not last. Around the end of November small caps started to stumble, and then from mid-December the momentum driving the mega caps also started to evaporate. The “narrative” that stocks such as Tesla would benefit from Elon Musk’s proximity to Trump and ensuing deregulation of the economy was exposed as what it had been all along — wishful thinking. Tesla has fallen almost 20% since then, with the S&P500 down almost 5%, erasing just about all its post-Trump gain.

Downturn


The South African market has mirrored this downturn. The Top 40 index peaked in late September and is now down almost 8%. The rand has similarly had a rough stretch; after a stellar 2024, it has weakened from R17.11 to over R19.17 against the US dollar.

Other risk indicators tell a similar story. Cryptocurrencies, poster children of the 2024 sugar-rush mini-bubble, have faltered. Bitcoin, the benchmark, has dropped nearly 15% since its December peak, now hovering just above $90,000.

But what is driving this sea of change? As predicted last year, interest rates play a pivotal role.

While the key 10-year benchmark the Treasury recovered from an initial post-election sell-off in late November, it has subsequently weakened sharply. US 10-year yields are now above 4.7%, roughly 65 basis points higher than they were as recently as early November when they were barely 4% (bond yields move inversely to prices). This is a stunning reversal. If it hits the key psychological barrier of 5%, things could get even more volatile. The last time it came close to this, in late 2023, equities tumbled.

Why should higher rates hurt risk assets? The most immediate answer is that they serve as a discount rate on valuations; the higher the risk-free rate, the more future cash flows will be discounted to achieve present valuations. This is especially critical for growth stocks whose profits might be further into the future or, more generally, less assured. This is why higher interest rates have hit assets such as Bitcoin, which obviously generates no earnings, and Tesla, which is highly sentiment driven, more than other stocks.

Second, there are real economic effects. Higher interest rates mean higher borrowing costs for families and companies, as well as further pressure on home sales and corporate expansion. Rising yields risk choking off any sustained economic expansion in the US, and indeed in Europe and South Africa. This then raises questions regarding the future profitability of companies and the potentially wishful high valuations they achieved towards the end of last year.

But the question remains, what is pushing rates higher? Three key factors stand out.

First, inflation in the US continues to outpace expectations, forcing the Federal Reserve to adopt a more hawkish stance. The Bank of America recently projected that the Fed might not cut rates at all in 2025, in stark contrast to last year’s predictions of steady rate reductions. Bond markets are even pricing in a 40% chance of a rate hike this year, according to Barclays strategists.

State of the economy

Second is the more general state of the economy. Jobs figures out at the end of last week show that the US labour market is, seemingly, not cooling at all. The report was indeed a blowout relative to expectations; 256,000 jobs added against an estimate of 160,000. Such robust growth should naturally lead to the steeper yield curve we have seen in the past few weeks.

Finally, the bond vigilantes are back. Bond traders alert to fiscal irresponsibility are smelling blood. Countries without a monetary backstop (like the ECB acts within the eurozone) or lacking a reserve currency (such as the US) are particularly vulnerable. The obvious example here is the UK, where 30-year government bond yields hit a 27-year high last week. Post-Brexit, UK gilts and the pound are increasingly behaving like emerging market assets, reflecting dwindling investor confidence in Prime Minister Keir Starmer’s Labour government and its embattled and seemingly witless Chancellor Rachel Reeves. UK bonds may now be a riskier bet than those of South Africa’s GNU-led government.

However, the US is not immune. Indeed, it was as recently as the 1990s that then president Bill Clinton faced bond market pressure to curb fiscal excesses, with 10-year Treasury yields surging from 5% to 8% within a year. Only after adopting conservative fiscal policies did yields retreat. President-elect Donald Trump would do well to heed this history. So far, however, he has shown little interest in addressing the ballooning US deficit beyond vague spending cut promises from Elon Musk’s Department of Government Efficiency.

Higher rates and their repercussions will probably dominate markets in 2025. Investors should keep a close eye on that US 10-year yield. If sanity does not return to fiscal policy in the US, the economy continues to run hot and interest rates stay higher for longer, then the year ahead could be a challenging one for markets. DM

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