Invezz Interviews CIO Tom Graff on Rising Yields and Stock Valuations

As long as inflation remains high and economic growth is solid, the Fed is going to remain in hiking mode. I expect Treasury yields to remain high or even go higher until something about the macro economy changes. If interest rates keep rising, it will be less about which sectors do well and more about what kinds of companies have the financial flexibility to adapt. Since high rates are being driven primarily by inflation, companies with more pricing power and manageable debt loads should be better positioned. The sectors that will struggle most are probably real estate, consumer discretionary, and possibly tech. The worry on tech would be more about valuation compression than the direct impact of higher rates.

High interest rates are negative for stocks all else being equal. If all else isn’t equal — for instance, if profit growth from AI continues to boom — then high rates won’t matter for stocks. To me, the biggest worry is that high rates hamper the profitability of data center projects, weighing on earnings for hyperscalers.

It wouldn’t be that hard to get to 6% Treasury yields. Right now, the market is pricing in a very benign Fed hiking cycle, maybe two to three more hikes and then cuts later in 2027. If that outlook merely changed to four to five hikes without any near-term cuts, that would probably be enough to get the 10-year Treasury into the 6% area. My sense would be that we’ll know if the first couple of rate hikes are impacting inflation relatively quickly, certainly within 6 months. If it becomes obvious that more hikes will be needed, the 10-year will rise rapidly.

Rising rates are a huge risk to the housing market. As we all know, home affordability is already challenged. Every 0.25% that mortgage rates go higher just makes it all the more challenging. If mortgage rates started to get into the 7 to 7.5% area, there is a non-zero risk that starts weighing on home prices.

When the Fed hikes rates, they are trying to get consumer spending to slow. That’s the mechanism by which higher rates lead to slower inflation. It is a delicate balance, though. If they hike rates too quickly, they might cause a recession. This is probably why Fed Chair Kevin Warsh hesitated to hike rates earlier in the summer. Financial stress is another major risk. Generally speaking, corporate balance sheets are in pretty good shape and profitability is strong. There are definitely pockets of risk, especially in the software sector. There are a lot of highly leveraged software companies that need to refinance debt from the 2019-2022 period and will be facing dramatically higher rates at the same time that AI is challenging their core business model.

I don’t think modestly higher rates cause any kind of slowdown in data center construction. However, there are already questions about how strong the return on investment will be for these projects. If the cost of debt funding keeps rising, those challenges become even more problematic. That could absolutely weigh on the stocks of some of the big AI companies.

Historically, crypto has had a relatively strong correlation with interest rates and the dollar. If the Fed is forced to keep hiking, I expect the dollar to rally substantially. I’d be very surprised if crypto performs well in such an environment.

[On increased capital expenditures] This is an unusual cycle. Spending on AI is crowding out a lot of other kinds of spending. Because companies view AI as so critical to future competitiveness, I don’t think rising rates will impact AI investment materially. It will probably have some effect on other kinds of business investment, but that growth is already very slow. I would be more inclined to bet that healthcare performs well in a high-rate environment. I think their pricing power would be strong, able to offset any increased interest costs.

Usually, rising rates cause the dollar to appreciate, and that often comes at the expense of emerging markets. In this environment, I’m not sure that matters as much for the AI darling countries, like South Korea and Taiwan. I think performance in those markets will be dominated by relative enthusiasm for semiconductors and memory stocks as opposed to anything about the dollar. In our view, places like China, other parts of South-East Asia, and Latin America are more vulnerable to a rising dollar. I would also be extremely careful with EM debt funds in that scenario. There could be material downside for US-based investors.