Defying Gravity

Warren Buffett once quipped “interest rates are to asset prices what gravity is to the apple,” illustrating that higher interest rates tend to have a gravitational pull-on stock valuations. This past week, gravity got stronger. The Federal Reserve (Fed) raised interest rates for the first time in three years, leading the yield on the 10-year Treasury note to reach 5% for the first time since 2007. The message from Fed policymakers was unmistakable: Rates are going higher and staying there longer. And yet, improbably, the stock market barely blinked. A handful of the largest technology companies simply kept climbing, defying the gravity that dragged much of the rest of the market lower.

The result was one of the most lopsided weeks in memory. The S&P 500 (S&P) finished essentially flat, closing at 7,650, while the tech-heavy Nasdaq Composite actually rose about 0.7%. Look beneath those headline numbers, though, and the picture is more nuanced. The Dow Jones Industrial Average (Dow) fell 1.7% in the week, the small-cap Russell 2000 lost roughly 1.5%, and the majority of stocks in the S&P 500 declined. The index held its ground only because its largest members, mega-cap technology and semiconductor stocks, rallied hard enough to offset the broad weakness beneath them.

The week’s defining event came Wednesday, when the Fed raised its benchmark interest rate by a quarter point to a target range of 3.75% to 4.00%, its first hike since July 2023. Just as notable as the move was the unanimity behind it: After three officials dissented in favor of a hike at July’s meeting, Chair Kevin Warsh managed to unite the entire committee at this meeting. The accompanying projections were firmly hawkish, with 12 of 18 policymakers penciling in at least one more increase before year-end and further hikes expected into 2027. Warsh used his press conference to underscore the Fed’s resolve on inflation, which has run above the central bank’s 2.0% target for years and, thanks to soaring energy costs, shows little sign of relenting. The takeaway for investors was simple: As long as the economy is strong and inflation runs above 2.0%, the Fed will keep rates higher for longer.

Nowhere was that message felt more acutely than in the bond market. The yield on the 10-year Treasury, the reference rate for everything from mortgages to corporate loans, climbed above 5% during the week to its highest level since 2007. The 2-year yield rose to about 4.74%, and the gap between the two narrowed, a flattening that reflects a market reacting to a higher-for-longer message. The 10-year Treasury yield reflects the cost of capital across the broader economy; higher rates sharpen the competition that bonds pose to stocks and complicate the fiscal backdrop for a government carrying more than $40 trillion in debt. It is the best reflection of gravity in Buffett’s metaphor.

The conflict between the United States and Iran has been one of the primary reasons inflation has lingered above the Fed’s 2.0% target. Both sides have taken steps to assert control of the Strait of Hormuz while negotiations to end the conflict remain volatile. Before the conflict, the strait saw 20% of the world’s oil supply flow through it. With supply essentially cut off, crude oil prices have hovered around $100 a barrel. The price of crude oil is directly tied to the price of diesel fuel, and diesel has come into focus in recent weeks as much of the global economy relies on it for everything from shipping goods to running farm equipment. The impact of more expensive diesel is quickly reverberating into the prices of other goods and services and is a key piece of headline inflation moving in the wrong direction.

The economic data released during the week painted a study in contrasts. On the strong side, the consumer remains remarkably resilient: Retail sales jumped 1.2% in August, well above the 0.7% economists had expected, with broad-based gains beyond autos and gasoline. The labor market looks equally sturdy, as initial jobless claims fell to roughly 196,000, near a six-decade low. On the softer side, the housing market continued to buckle under the gravity of high mortgage rates, with housing starts falling 2.6% to their lowest level since last October, existing-home sales declining 2.0%, and homebuilder confidence slipping further. The Conference Board’s Leading Economic Index, meanwhile, edged down 0.1% in August, its first decline since March, hinting that growth will slow in the months ahead. The economy, in short, looks strong enough to justify the Fed’s hawkishness while showing the first signs of a cooling that higher rates are designed to produce.

Which brings us back to gravity. Faced with a higher-for-longer Fed and a 5% risk-free rate, investors did what they have done for much of this cycle: They crowded into the mega-cap technology giants, prizing their durable earnings, fortress balance sheets, and exposure to the artificial intelligence (AI) boom. Chipmakers led the tape even as a debate broke out over AI’s trajectory, with some of the industry’s own leaders reportedly urging a slower, safer pace of development. The rate-sensitive remainder of the market fared far worse. Small caps, industrials, transports and consumer discretionary shares all fell, with several of those groups trading lower five weeks in a row and falling below their 200-day moving average.

Gravity, of course, always wins in the end; the only question is when. The higher the 10-year yield climbs, the greater the downward pull-on valuations and the harder it becomes for even the strongest companies to keep levitating above it. For now, the giants are still aloft, and the index they dominate sits within striking distance of its record. But a narrow market is a fragile one, and the Fed has made clear it is in no hurry to lighten the load. The questions for the weeks ahead are whether energy prices, and with them inflation, finally ease; whether the economy’s soft spots begin to spread; and how long a handful of high-flyers can keep defying a force that, sooner or later, tends to reassert itself.

Looking forward to this week it will be a relatively quiet week of economic data. Investors will parse durable goods orders, new home sales and the flash purchasing managers’ surveys for September. With the Fed out of its blackout period, a parade of policymakers will return to the podium, and every remark will be scrutinized for clues about the pace of further tightening. Oil and the situation in the Strait of Hormuz will be closely watched as investors hope for a lasting resolution.

Forecast and prior figures are shown where confirmed; blanks indicate consensus estimates still to be set or reports without a standard forecast. Release dates are approximate and subject to change.

Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Market Commentary/Market.

5949006 Exp. 09/30/2029