Capital Markets Undergo Notable Repricing in Response to Rising Inflation and Higher Interest Rates | U.S. Bank (2024)

Capital markets enjoyed a solid rebound in 2023 following a difficult year in 2022, when both equity and fixed income markets suffered significant declines. Equity markets were particularly strong in 2023, with the benchmark S&P 500 index gaining more than 26%, primarily on the strength of strong performance from technology companies. Bond markets overcame a challenging environment to generate modestly positive returns.

“The macroeconomic backdrop for 2024 is one of slowing growth,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “At the same time, inflation has slowed considerably from peak levels reached in mid-2022, though cost-of-living changes remain somewhat elevated compared to what we became accustomed to in recent decades.” Haworth believes the current environment offers potential for both equity and fixed income investors.

Current capital market drivers

While surging inflation and rising interest rates were driving forces in the market’s challenging 2022, the market’s recovery that began in 2023 was supported by declining inflation and surprisingly solid economic growth. In today’s environment, Haworth sees three primary factors at work:

• Slowing growth and falling inflation. Haworth says it appears likely that the pace of U.S. economic growth could slow in 2024, though the current U.S. Bank forecast is that a recession is avoided. Inflation, which declined significantly in 2023, is expected to further decline in the months to come. However, inflation in recent months has stabilized in the low 3% range.

• Improved corporate earnings. Earnings, or a company’s profits, are typically one of the biggest drivers of capital market performance. “We’re in the second quarter of an earnings recovery,” says Haworth, “in contrast to an earnings contraction that was underway in the first half of 2023.” Haworth says that provides support to the markets, as earnings growth helps lay the groundwork for rising stock prices.
• Changes to Federal Reserve (Fed) interest rate policy. The Fed raised rates 11 times between March 2022 and July 2023 in an effort to slow economic growth and quell the inflation threat. “Fed rate hikes weren’t unlike being on a treadmill where the incline is being increased,” says Haworth. “It made the environment more challenging for companies and investors.” The Fed has indicated that rate hikes are likely done for the current cycle. “That could help the economy continue to expand and help stocks continue to do well,” says Haworth.

  Haworth says the environment may also become more productive for fixed income investors. “Interest rates are near their highest levels in 14 years,” says Haworth. “If the Fed begins to lower the federal funds rate it controls sometime in 2024, that should help bring bond yields down across the broader market, which would boost returns for bond investors.” In the meantime, investors can earn much higher yields from bonds than they have for more than a decade.

  See Also

  What Are Some Examples of Capital Markets?

The current capital market environment remains constructive given the ongoing strength of the economy, but investors need to be prepared for periods of market volatility. Ultimately, factors like corporate earnings and the direction of interest rates will have the greatest impact on equity and fixed income markets. However, the potential exists for other events to temporarily impact the markets and potentially contribute to investor uncertainty. Read more about our capital market perspective in our quarterly investment outlook.

Capital markets explained

Here are answers to some fundamental questions that may help you better understand capital markets and how they work.

What are capital markets?

Capital markets are a way to bring together individuals or institutions with money (also known as capital) they wish to invest, and various entities that seek money to underwrite costs to meet specific purposes. Capital markets also facilitate the issuance of securities on an exchange, where stocks and bonds are offered by those seeking capital, to be purchased by investors seeking to put capital to work.

For example, government entities regularly issue debt securities (bonds) to meet costs for major capital projects or, in the case of the federal government, finance day-to-day expenditures. Investors, in effect, lend money to the government entity by purchasing a bond. The borrower is required to pay interest on a timely basis and repay principal when the bond matures.

What are types of capital markets?

Capital markets are most commonly made up of stock and bond markets.

• Stock (equities) is issued by a corporation, providing an ownership stake in the firm. Individuals and institutions can purchase stock in the firm, obtain voting rights as a shareholder, and be a recipient of dividends paid out by the corporation from its earnings (profits). Stock values can rise and fall, and investors can re-sell shares through an exchange on the secondary market, which is where bonds or shares of stock are bought and sold after their initial public offering.
• A variety of entities issue bonds, such as governments, school districts and corporations. By purchasing a bond, the investor becomes a lender and is due interest and principal payments. Bondholders always take priority over stockholders when it comes to repayment, should the entity that issued the security face financial difficulty, such as bankruptcy.

How do capital markets work?

A key to capital markets is the issuance of securities. Entities seeking to raise capital issue debt or equity securities that are exchanged with investors. A corporation, for example, may issue new shares of stock, at a set price. However, once on the open market, the price of a security is generally always changing, reflecting demand in the market.

When raising capital, companies or entities may issue new shares of a stock or bonds, with proceeds from investors going directly to the issuer to meet its current financial purposes. Original issues of stocks and bonds are not always accessible to individual investors, such as in an initial public offering (IPO) of stock. Most individuals purchase stocks on the secondary market, where those who previously purchased stocks or bonds can re-sell the securities they hold.

How do capital markets differ from financial markets?

There are similarities between the two; however, capital markets typically refer to the issuance of new securities to raise capital, while financial markets can refer to all forms of securities trading.

Financial markets encompass a wide variety of exchanges involving traditional securities like stocks and bonds, as well as other types of assets and contracts. Most individuals trade securities on the secondary market.

Talk to your financial professional

As you assess your own financial goals, understanding the current and anticipated performance of capital markets may help you more effectively position your assets to achieve your objectives. Discuss your circ*mstances with your financial professional to help determine the best steps to consider in today’s capital markets.

Our investment strategies are designed to weather all types of market cycles. Learn about our investment management approach.