Rate spike could skewer stocks, too

Surprisingly, stock investors may have more to worry about than bondholders when it comes to rising interest rates. Obviously, rising interest rates have an inverse effect on bond prices, but with global growth sluggish at best, experts say surging rates could put extra pressure on already thin company earnings. Three out of five companies in the S&P 500 beat earnings estimates in the first quarter, but only 46% beat revenue estimates, according to research firm FactSet Research Systems Inc. That's the third quarter out of the last four that the majority of S&P 500 companies have disappointed on sales. One of the biggest reasons there's been a disconnect between income and revenue is that companies have been propping up earnings through cost-cutting, said Russ Koesterich, chief investment strategist at BlackRock Inc. The cost cutting is keeping margins at companies high even though top- line growth has been tepid, he said. Companies have also been helped by the fact that their three largest costs — wages, cost of capital, and raw materials — have been flat or falling. With interest rates spiking — the yield on the 10-year Treasury has risen almost 50 basis points this month — the cost of capital is rising and could shrink margins if sales stay low. “If you believe stocks are cheap than you assume companies can keep up these margins,” Mr. Koesterich said. “Over the long-term revenues are a cause for concern.” The biggest thing to worry about with rising interest rates is the speed at which they keep going up, said Bob Doll, chief equity strategist at Nuveen Asset Management LLC. If interest rates slow their roll, it shouldn't pose a big problem for stocks. “The market can tolerate more rise in rates,” he said. “But not at this pace.” Eventually though, revenue is going to have to pick up the pace to keep stocks chugging along after this year's already sizable 16% gain through May 29. “If we're going to have a decent leg up from here, there's going to have to be earnings and revenues,” Mr. Doll said. One positive sign for stocks is that there's been a rotation from defensive stocks' to cyclical stocks' leading the market over the last month. The technology, energy, and industrial sectors are all up between 4% and 5% over the last month, while two of this year's early leaders —utilities and consumer staples — are down 9% and 1.3%, respectively. “It's a good sign for the economy,” Mr. Doll said.