Equities

On Hikes and Highs

Most developed-market central banks are now raising short-term rates to contain inflation on account of higher energy prices. The Fed hiked on September 16 for the first time since 2023, and the 10-year Treasury yield touched 5.13% this month, its highest level since 2007. Despite those headwinds, the S&P 500 sits within roughly 2.5% of the record it set in August and Japanese equities recently set fresh all-time highs. We think equities can still deliver positive returns through year-end.

Who Is Hiking, and How Far Will They Go?

Since May, the Reserve Bank of Australia, the Reserve Bank of New Zealand, the European Central Bank (ECB), the Bank of Japan (BoJ) and the Fed have all raised rates. The Riksbank and the Bank of England (BoE) are expected to follow shortly. Many of these moves reverse cuts made in 2025. In the Fed's case, it is unwinding the "insurance cuts" it made when the U.S. labor market wobbled late last year. In our view, the reason for a hike matters. Unwinding insurance cuts is a very different exercise from chasing runaway inflation. As long as volatility at the long end of the curve stays anchored, we believe staying overweight stocks versus bonds is the right call.

Don't Stocks Struggle When the Fed Hikes?

In the short run, yes. Goldman Sachs looked at seven Fed hiking cycles over the past few decades. The S&P 500 averaged a -2% return in the three months after the first hike, then gained an average of 9% over the following 12 months, with positive 12-month returns in every cycle except 2022.¹ The 1997 cycle is the extreme case: the S&P 500 fell 10% around a single 25 basis point (bp) hike. Even then, stocks bottomed once the market stopped pricing more tightening and reached new highs within three months.¹

Based on our current views, a sharp correction is not our base case. Still, as long as oil prices and U.S. rates keep rising, we expect volatility to stay elevated. For us, that means opportunities to buy stocks at a discount. Our recommendation is to know what you want to own before those opportunities show up (more on that below). Rates may stay choppy, but we are more confident that stocks can find their footing before year-end, for three reasons.

Earnings Matter More Than Rates

The S&P 500's forward P/E has compressed from 22x at the start of the year to 19x, even as the index trades near its record high.¹ That means forward earnings estimates have done the lifting. Some of the compression reflects higher rates, and some reflects skepticism about AI and how durable recent earnings strength is. Relative to bonds, stocks look about the same as they did a year ago. The gap between the S&P 500 earnings yield (5.2%) and the real 10-year Treasury yield (2.6%) is roughly 270 bps, and outside of brief drawdowns it has held steady for two years.¹ Put another way, P/E compression has mostly tracked real yields, and investors have not demanded a bigger risk premium to own stocks.

How much further can yields rise before earnings stop carrying the market? Many strategists reduce stocks versus bonds to the Fed Model, which compares the equity earnings yield with the nominal 10-year yield. We are less convinced. However, as the 10-year approaches 5.5%, it is true that equity multiples have tended to come under pressure. In our view, the best way to navigate that ceiling is to focus on quality companies with high returns on equity and assets.

Turning to the balance sheet, most U.S. large-cap debt is fixed-rate and long-dated, so net borrowing costs have risen only modestly. According to Goldman Sachs, interest coverage for the aggregate S&P 500 ranks in the 99th percentile of the past 20 years, and coverage for the median stock ranks in the 68th.¹

Finally, we think rate volatility matters more than the level of rates. Stocks have usually posted positive returns alongside rising yields unless the move was fast enough to upset the apple cart. Today that works out to about 50 bps in a month or 30 bps in two weeks.¹ The speed of September's Treasury selloff helps explain why stocks wobbled. A broader hiking cycle that pushes long yields sharply higher would weaken the earnings anchor.

All Stocks Are Not Created Equal

Goldman calculates that a company needs two percentage points of extra long-term growth to offset a one percentage point rise in its cost of equity.¹ Companies with high returns on capital that fund capex and research and development from internal cash flow are best placed to clear that bar. In our view, companies that screen well on both growth and profitability may weather this cycle better than most.

The shape of the yield curve matters too. Bear-flattening episodes, like the one around the Fed's September meeting, have historically favored Technology. Bear-steepening episodes have tended to favor cyclicals such as Energy and Financials. Over time, Financials have tended to benefit from higher rates through wider net interest margins, even though their performance over the past month was less compelling.

Japan: A Rising-Rate Beneficiary

After decades of near-zero rates and deflation, Japanese companies still have some of the lowest nominal borrowing costs in the developed world. That is true even after the BoJ lifted its policy rate to 1.25% on September 18, the highest since 1995.2 Gradual normalization supports bank earnings and signals confidence that wage and price gains are sticking.

Historically, higher U.S. rates meant a weaker yen, which helped exporters by lifting yen-denominated sales. The yen has since become a political issue in both Washington and Tokyo, but Japanese companies do not necessarily need a weaker currency to grow. Their forecasts are conservative. Major manufacturers assumed ¥151.4 per dollar for fiscal year 2026. After the BoJ's September hike, the yen traded near ¥157, leaving a healthy cushion relative to the forecast.

In our view, the policy paths of the Fed and BoJ will be a key driver of the exchange rate. With the Fed at 3.75% to 4.00% and the BoJ at 1.25%, U.S. short rates hold an advantage of roughly 250 bps or more. For a U.S. investor, that gap is roughly the annual carry earned from hedging the yen. An unhedged position only comes out ahead if the yen appreciates by more than about 2.5% per year, every year, which is not our base case.

Many investors are concerned about the headwinds from rising rates, but history and today's fundamentals suggest current levels can be digested by markets. The next few months bring a busy calendar: third-quarter earnings season, the inflation reports ahead of the Fed's December meeting, and further decisions from the ECB and BoJ. Each one is a chance for markets to reprice, and pullbacks around them may offer better entry points for investors with a shopping list ready. In our view, patience and selectivity should be rewarded more than trying to time the peak in rates.

¹ Source: Goldman Sachs Global Investment Research, as of 9/11/26. 2 Rate and currency data: Federal Reserve, Bank of Japan, Bloomberg, as of 9/22/26.