Understanding capital markets

2022 was a difficult year for capital markets. It was a sharp contrast to the environment in 2020 and 2021 when stocks generated double-digit gains. Higher inflation and interest rates also represented a striking change for the bond market; 2022 concluded 40-year period characterized by low inflation, declining interest rates and stable-to-rising bond prices.

“When interest rates or inflation rise or fall, all asset prices change as well,” says Rob Haworth, senior investment strategy director at U.S. Bank. These and other economic factors can directly impact investment performance, and the environment remains challenging for capital markets as several variables could affect the future direction of the markets.

Current capital market drivers: High interest rates and corporate earnings

While surging inflation and rising interest rates were driving forces in the market’s challenging 2022, we attribute continued market volatility in 2023 primarily to two factors:

• Slowing economic outlook. The Federal Reserve’s (the Fed’s) intentional efforts to tamp down economic growth through various measures, including major increases in the target federal funds interest rate it controls, contributed to a significant slowing of the economy in 2022, a trend that carried over to the first quarter of 2023.
  
  While higher interest rates may create more attractive investment opportunities in the bond market, they also mean higher borrowing costs for consumers and businesses. That could result in reduced lending activity, further slowing the economy. A key question being considered in 2023 is whether the Fed can succeed in stamping out higher inflation without pushing the economy into a recession. If the economy weakens, it could create more challenges, particularly for the equity market.
  
  
• Corporate earnings. Earnings, or a company’s profits, are typically one of the biggest drivers of capital market performance. In 2022, other issues like inflation and the Fed’s interest rate hikes had a major influence on stock performance, but in 2023, corporate earnings are back at center stage.
  
  “Over time, two factors drive stock prices – the level of earnings, and the multiples that investors are willing to pay for earnings,” says Haworth. While corporate earnings (profits) held up well until now, multiples, which are typically reflected in the price-to-earnings ratio of a stock, have fallen.
  
  “Multiples tend to be higher when interest rates are low,” says Haworth, “but higher rates mean investors are less willing to pay a premium for stocks.” Higher rates make bonds, which generally carry less risk than stocks, a more desirable investment consideration. “The more income a bond can generate, the less appealing it is to pay high prices for stocks based on the uncertainty that future earnings will continue to flourish,” says Haworth. This contributed to the challenging environment for stocks.
  
  “We don’t yet have a stable view of earnings expectations as we look out over the full year,” says Haworth. He notes that market expectations have downgraded overall expected earnings for the year. “Higher borrowing costs may cut into earnings, and may also temper new corporate spending, which could have a negative economic impact,” says Haworth.

The current capital market environment holds a number of questions about the trajectory of the economy. If interest rates continue to rise, the economy could continue to slow, which may be challenging for corporate earnings. Read more about our capital market perspective in our quarterly investment outlook.

Capital markets explained

Here are answers to some fundamental questions that may help you better understand capital markets and how they work.

What are capital markets?

Capital markets are a way to bring together individuals or institutions with money (also known as capital) they wish to invest, and various entities that seek money to underwrite costs to meet specific purposes. Capital markets also facilitate the issuance of securities on an exchange, where stocks and bonds are offered by those seeking capital, to be purchased by investors seeking to put capital to work.

For example, government entities regularly issue debt securities (bonds) to meet costs for major capital projects or, in the case of the federal government, finance day-to-day expenditures. Investors, in effect, lend money to the government entity by purchasing a bond. The borrower is required to pay interest on a timely basis and repay principal when the bond matures.

What are types of capital markets?

Capital markets are most commonly made up of stock and bond markets.

• Stock (equities) is issued by a corporation, providing an ownership stake in the firm. Individuals and institutions can purchase stock in the firm, obtain voting rights as a shareholder, and be a recipient of dividends paid out by the corporation from its earnings (profits). Stock values can rise and fall, and investors can re-sell shares through an exchange on the secondary market, which is where bonds or shares of stock are bought and sold after their initial public offering.
• A variety of entities issue bonds, such as governments, school districts and corporations. By purchasing a bond, the investor becomes a lender and is due interest and principal payments. Bondholders always take priority over stockholders when it comes to repayment, should the entity that issued the security face financial difficulty, such as bankruptcy.

How do capital markets work?

A key to capital markets is the issuance of securities. Entities seeking to raise capital issue debt or equity securities that are exchanged with investors. A corporation, for example, may issue new shares of stock, at a set price. However, once on the open market, the price of a security is generally always changing, reflecting demand in the market.

When raising capital, companies or entities may issue new shares of a stock or bonds, with proceeds from investors going directly to the issuer to meet its current financial purposes. Original issues of stocks and bonds are not always accessible to individual investors, such as in an initial public offering (IPO) of stock. Most individuals purchase stocks on the secondary market, where those who previously purchased stocks or bonds can re-sell the securities they hold.

How do capital markets differ from financial markets?

There are similarities between the two; however, capital markets typically refer to the issuance of new securities to raise capital, while financial markets can refer to all forms of securities trading.

Financial markets encompass a wide variety of exchanges involving traditional securities like stocks and bonds, as well as other types of assets and contracts. Most individuals trade securities on the secondary market.

Talk to your financial professional

As you assess your own financial goals, understanding the current and anticipated performance of capital markets may help you more effectively position your assets to achieve your objectives. Discuss your circumstances with your financial professional to help determine the best steps to consider in today’s capital markets.

Our investment strategies are designed to weather all types of market cycles. Learn about our investment management approach.