Why stocks are shrugging off rising interest rates
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The escalating war with Iran and rising energy costs helped push up borrowing costs across the U.S. economy last week. Stocks largely yawned.
Why it matters: It suggests that investors think it will take more than higher interest rates to slow the engine powering much of the market.
The latest: The yield on the 10-year U.S. Treasury climbed to 4.97% Friday, near 2007 levels. A month ago, it was at 4.69%.
Zoom out: That Treasury yield serves as the foundation for borrowing costs throughout the economy, from car loans to mortgages to multibillion-dollar corporate bond offerings.
Those additional costs are a big part of the reason higher interest rates have long been seen as stock market kryptonite.
- But this year's higher rates and even the jump over the last few weeks haven't clobbered stocks — at least not yet.
- Year to date, the S&P 500 is up about 12%. Even with the run-up in yields last week, the index ended down less than 1%.
Between the lines: What accounts for the stock market's resilience? Profits, for one thing.
- S&P 500 companies have posted rip-roaring profit growth in recent quarters, including a jump of more than 50% in earnings in the most recently reported quarter, compared with the prior year.
- And what accounts for those profits? Any regular reader of Axios Markets knows the answer: It's the massive amount of capital spending for the AI boom.
Yes, but: More and more, that boom is being funded by borrowing. So shouldn't rising rates and borrowing costs throw at least some sand in the gears?
- In theory, the answer is "yes."
- But in practice, it can also be "no."
Zoom in: In competitive industries, higher rates would be something of a problem, as they would ultimately start to cut into relatively low expectations for profitability.
- If rising rates eat away deeply at those expected returns, the payoff on investing to build that business is no longer worth the squeeze.
Reality check: But AI doesn't really exist as a profitable business yet.
- So the profits are largely in the form of expectations in the minds of investors, analysts and executives.
- And as you might expect, they are sky-high.
Stunning stat: A recent report from Morgan Stanley analysts estimated that hyperscalers could generate roughly $12 billion of after-tax operating profit per gigawatt of computing power, which would be a return on invested capital of roughly 30% — an unusually lucrative opportunity.
- Morgan Stanley analysts also sketched out a number of paths for hyperscalers and AI players that could lead to between 25% and 50% returns on invested capital, or ROIC. That's the key metric that everyone is watching on AI profitability.
The bottom line: When expectations for profitability are that high, it would take an enormous increase in borrowing costs to make a dent in profit expectations big enough to quell the AI boom.
What they're saying: "When you have 25%+ ROIC expectations, the sensitivity to the cost of borrowing for some of these companies is substantially less," Morgan Stanley fixed-income analyst Vishwanath Tirupattur tells Axios.
- "It doesn't mean that borrowing cost doesn't matter. It means that in a certain range, for certain issuers, it's less sensitive than some others."
The big picture: This is what happens during a market boom.
- If additional borrowing expense doesn't really matter to investors — who are willing to pay a few extra percentage points in financing for the opportunity to make life-changing returns — it sometimes means rates have to go a lot higher than people expect before things cool off.
