Where Are Stocks Headed After The Fed Rate Hike?

Strong corporate earnings and fundamentals help cushion the impact of rate hikes
Expanding AI spillover effects benefit supply chains across the US and Asia
Uncertainties surrounding Middle East tensions, oil prices, and inflation could heighten short-term market volatility

US-Iran conflict sent oil prices higher and pushed up inflationary pressures, prompting the Fed to raise rates by a quarter percentage point to tackle rising consumer prices. Amid higher borrowing costs, the market's key concern is: Willincreasing interest rates weigh on the appeal of stocks?

We believe the backdrop of this rate hike differs from previous occasions. Currently, robust corporate earnings growth, improving productivity, and sustained AI development suggest that the market may have the resilience to absorb the impact of higher rates.

AI spillover effects fuel momentum in global growth

Persistent AI investment has helped support stable growth across markets. US September manufacturing PMI expanded to 57, marking a 52-month high; Japan's second-quarter GDP growth exceeded market expectations, while manufacturing activity in South Korea and Taiwan continued to grow. The International Monetary Fund (IMF) estimates that global economic growth could reach 3% this year, slowing from last year's 3.5%, with uneven growth prospects across regions. The conflict in the Middle East weighs on energy importers and more fragile economies, but markets benefiting from AI development are likely to continue to prosper.

AI development is creating a spillover effect, bolstering demand for hardware, infrastructure and power, and subsequently benefiting the energy, materials and industrials sectors. S&P estimates that AI capex from just a few US hyperscalers could exceed US$1.3 trillion in 2027. In addition, massive investment needs are steadily translating into corporate revenue, profits and cash flow along the supply chain. Data showed that S&P 500 companies reported a more than 50% year-on-year jump in second-quarter earnings, the strongest growth since the first quarter of 2021. Even though analysts have repeatedly upgraded earnings estimates, more than 85% of companies posted stronger-than-expected EPS growth, underscoring stable market fundamentals. From a geographical perspective, the US, as a leader in innovative technology, benefits from sustained demand growth for AI agents, software, and semiconductors, while Asia plays a pivotal role in areas such as semiconductors, memory, printed circuit boards, servers, and electronic assembly across the supply chain.

Generally speaking, rising rates will increase corporate financing costs and reduce the value of future cash flows, but they do not necessarily weigh on profitability or dampen the appeal of equities. If monetary policy tightens alongside an economic recession, it may take a toll on the business outlook, in turn affecting stock performance. However, if inflation remains stable, productivity improves, and demand increases, companies with structural growth potential could see stronger profitability and cash flow, offsetting the impact of elevated rates and providing support for stock valuations. As long as the pace of earnings growth exceeds that of rate increases, the intrinsic value of stocks can remain supported.

Meanwhile, we tend to view this US rate hike as unlikely to mark the start of a new tightening cycle. At this stage, there is no sign of broad-based inflationary pressures beyond higher energy prices, and apparent secondary effects have yet to emerge. The rebound in inflation is primarily driven by higher oil prices. Whether oil prices will remain elevated depends on the US-Iran conflict and related geopolitical developments. Should the situation ease, inflationary pressure may also subside.

Looking ahead, the market is facing multiple crosscurrents. Stocks are supported by robust macroeconomic conditions, solid corporate profitability, and ample free cash flow. However, uncertainties surrounding oil prices, inflation, and the rate trajectory may increase market volatility. Investors looking to capture the growth potential of stocks while diversifying away from the risks of a single asset class could consider a multi-asset strategy as part of their investment portfolio, helping to optimise portfolio stability by allocating across different sectors, markets, and asset classes.