With 2025’s first month of trading in the books, concern about the level and direction of U.S. interest rate lingers. But what matters more, the actual level of interest rates or the pace of interest rate changes?
Historically, high interest rates tend to negatively impact equity market valuations, leading to lower S&P 500 price/earnings ratios. Conversely, the S&P 500 has generally traded at higher P/E ratios when interest rates are lower.
As we noted in last month’s Roundhill Roundup, investors up to this point have generally been comfortable paying the “dream premium” for some of the growthiest corners of the market. This thinking has been challenged in the short-term as the market adjusted rate cut expectations, but ultimately, the current level of interest rates relative to history does not appear to be a massive risk for market multiples.
In our view, the velocity of interest rates changes can have a bigger influence on equity market performance as investors tend to focus more on direction as opposed to the absolute level. When evaluating three-month changes in the U.S. 10-year yield back to 1962, S&P 500 forward performance appears to be impacted by extreme moves. When the U.S. 10-year yield declines sharply over a three month period (buckets 1 & 2), the S&P 500 has responded positively over the subsequent three months with 5.0% and 4.2% average returns, respectively. Conversely, S&P 500 performance is generally more muted following sharp 3-month rises in the U.S. 10-year yield. These extreme rises in the 10-year are in buckets 9 & 10, and have led to an average S&P 500 forward return of 0.8% and 2.2% in the following three months respectively.
The U.S. 10-year yield rose from 3.60% on September 17, 2024 to an intraday high of 4.81% on January 14, 2025, and registered multiple readings in the 8-10 buckets. U.S. bond yields have since eased off their January 2025 highs. In our view, rate stability accompanied by moderated fluctuations in the U.S. 10-year yield would lead to less market discomfort going forward and may in fact be supportive if we see a leveling out of rates.
Investor anxiety quickly pivoted from interest rates to market disruption within the AI industry by the end of January. Chinese startup DeepSeek shocked the technology world with reports that its most advanced large language model performed in-line with Microsoft’s OpenAI at a fraction of the investment cost and energy usage, calling into question spending on current AI initiatives, infrastructure, and the need for alternative power solutions like nuclear energy.
While the knee jerk reaction from the market was decidedly negative, skepticism on DeepSeek’s true fundamental impact remains. The price behavior of certain Magnificent Seven members caught our attention as well. While Nvidia bore the brunt of investor scrutiny in the wake of DeepSeek’s news, Meta, an open source AI player itself, actually traded to new all-time absolute and relative price highs versus the S&P 500 on January 27. Meta finished higher on the week, showing a divergence in price from the initial negative fundamental narrative. In our opinion, DeepSeek was more an excuse to sell highfliers like Nvidia due to the fragility of markets as opposed to a true threat to the AI story. In a recent Bloomberg survey, 88% of respondents said that the latest model release from DeepSeek will have little to no impact on US tech players’ performance in the coming weeks.
On last week’s earnings calls, commentary from Mark Zuckerberg of Meta and Tim Cook of Apple seemed undeterred in the wake of DeepSeek. Zuckerberg “would bet that the ability to build out this kind of infrastructure will be a major advantage” while Cook stated “innovation that drives efficiency is a good thing.” This is a fundamental benefit and risk to open source code.
Critically, DeepSeek’s latest breakthrough does not appear to be anything near a death knell for the AI industry and its planned spending, but further commentary from the ongoing earnings season should provide real-time color on DeepSeek’s perceived influence.
As of January 31, 178 (or ~36%) of the S&P 500 have reported financial results, with roughly 75% reporting positive earnings surprises. Currently, Communications, Financials, and Technology are estimated to post the highest earnings growth rates among S&P 500 sectors, while Industrials, Energy and Materials are expected to see earnings growth fall. The S&P 500 is estimated to see 4Q’24 earnings grow 11.5%, up from 9.6% on January 1.
From a revenue perspective, Technology, Health Care, and Communications are leading in blended growth rates, while Materials, Industrials, and Energy are expected to lag in revenue growth for the quarter. The S&P 500 has seen revenue growth for the quarter revised higher, up from 4.1% on January 1, 2025 to 4.6% on January 31, 2025.
Meta, Microsoft, Tesla, and Apple commenced earnings for the Magnificent Seven last week. Reporting on January 29, Microsoft and Meta both beat on the top and bottom line while Tesla missed on both. The next day, Apple followed up the group with a double beat on earnings and revenue. As of week-end, these four have combined for a 5.9% earnings surprise, but combined for an average 1-day stock price change of just -0.61%. Alphabet, Amazon, and Nvidia remain. Despite nuanced sets of tailwinds and headwinds for each company, the Magnificent Seven’s aggregate results and forecasts for future growth will be crucial for the broader equity market.
We are in the third year of a bull market and are starting to see its fragility at this stage of the cycle. While there remains a strong bid for stocks driven by long-term asset allocation flows, the growing participation of retail investors, and old fashioned animal spirits, we’re seeing how sensitive investors can be to negative surprises and worse-than-expected news. The proliferation of algorithmic trading, leveraged ETF resets, and the influence of options dealers have further exacerbated excuses to sell. A single piece of bad news can catalyze a pronounced price reaction faster than fundamentals ever could.
Last Monday’s DeepSeek-driven selloff caught investor attention, while this week has been all about tariffs. The looming threat of U.S. tariffs on Canada, Mexico, and China has introduced another layer of uncertainty and could contribute to market volatility over coming weeks. President Trump has made it clear he intends to use tariffs to enact change and the question will be if the market is merely in a digestion phase or pricing in more serious economic consequences.
The “shoot first, ask questions later” approach shows the market has become conditioned to consistent, predictable growth paired with the narrative du jour of AI spending. Looking ahead, investors have a lot to be excited about, but there is a clear priority to protect historic gains made over the last two and half years. 2025 will likely be trickier than 2024, but opportunities remain.
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