The Economy vs. Rates Debate

Goldman Sachs (NYSE: GS  ) released some impressive second-quarter numbers this morning. Revenue increased 38% to $5.51 billion, and the firm grew earnings 71% to $1.19 billion ($2.31 per share) from $695 million ($1.36 cents per share) a year earlier.

The strong results were no surprise, really. The ever-strengthening economy and renewed interest in equities has been a boon to the likes of Morgan Stanley (NYSE: MWD  ) , Bear Stearns (NYSE: BSC  ) , Citigroup (NYSE: C  ) , and even discount brokers such as Ameritrade (Nasdaq: AMTD  ) .

However, investors have been convinced that rising interest rates will hurt the bottom lines of the Wall Street powerhouses. And the stocks have been sliding for several months now. But interest rates are only part of the picture. What happens to earnings depends primarily on economic conditions and secondarily on interest rates.

The last time the Fed raised rates in 1998 and 1999, the banks and brokerages didn't start stumbling until about two years into rate hikes, and then only as the economy shut down. In 1994, the stocks traded sideways while rates were hiked, but then took off along with the broader markets. The time before that was in the late 1980s. The economy tipped over the edge into a mild recession soon after, so the stocks didn't perform well then either.

What is clear is that a strong economy can more than offset any negative impact caused by interest rate hikes. What isn't clear is when investors will stop worrying and selling the stocks. It could take a few quarters of rate hikes and continued strong earnings before people are convinced it's safe to get back in again.

Fool contributor Mark Mahorney doesn't own shares of any companies mentioned.


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