Margin of Safety Investing in a World with Interest Rates: A Phase Demanding Sector Selection
Margin of Safety Investing in a World with Interest Rates: A Phase Demanding Sector Selection
As U.S. long-term interest rates rise to levels not seen in decades, the stock market as a whole has not shown a major collapse, but beneath the surface, capital is rapidly shifting between industries and stocks. The U.S. 30-year Treasury yield has reached 5.4%, its highest level in about 20 years since 2004, and the 10-year Treasury yield has also risen to the mid-5% range, a level not seen since 2007. Domestically, the yield on newly issued 10-year Japanese government bonds rose to 3.055%, up 0.070% from the previous business day, marking its highest level in approximately 30 years since August 1996.
Adapting to a ‘new normal’ where interest rates remain structurally high is no longer just about responding to a temporary adjustment phase, but has become a challenge that forces a redefinition of asset valuation itself. In such an environment, the concept of a ‘margin of safety’ advocated by value investing luminary Seth Klarman—the disciplined approach of collecting assets where there is a discrepancy between calculated intrinsic value and market price—is being reconsidered.
Historical Patterns of Interest Rate Hike Phases and the Current Situation
Looking back at past rate hike cycles, while U.S. stocks tend to fall in the short term immediately after the Federal Reserve (FRB) begins raising rates, they often turn upward 12 months after the start. Some analyses suggest that in cycles with a fast pace of rate hikes, returns are often negative for 1 to 12 months after the start, whereas in cycles with a gradual pace, returns are often positive, with some exceptions.
The forward price-to-earnings ratio (PER) of the S&P 500 has fallen from 22x at the beginning of the year to 19x, but the relative valuation of stocks against bond yields has remained largely flat. The equity risk premium, which is the difference between the S&P 500 earnings yield (5.2%) and the real inflation-adjusted 10-year Treasury yield (2.6%), is approximately 270 basis points, and has remained relatively stable over the past two years, excluding short-term sharp declines.
While some analyses suggest that historically, stock returns in phases where the 10-year Treasury yield is in the 5% range tend to be lackluster compared to other interest rate ranges, other analysis results show that the average annual growth rate from this level has reached 11.1%, leading to divided evaluations.
FOMC Rate Hike Decision and the Future of FRB Organizational Reform
On September 16, 2026, the FOMC (Federal Open Market Committee) unanimously decided to raise the target range for the policy interest rate by 0.25% to 3.75-4.00%. This is the first rate hike since July 2023, and the market has priced in a reasonably high probability of an additional rate hike at the October meeting. The policy rate outlook indicated by the dot plot was slightly revised upward, but the median shows a forecast of one more rate hike within the year and no rate hikes in 2027.
FRB Chair Kevin Warsh has begun organizational management reforms, including a review of forward guidance, and has launched five task forces inviting experts, aiming for conclusions by the end of the year. The ‘dot plot’ itself, which publishes policy rate forecasts quarterly, is also believed to be under review, including the possibility of its abolition, suggesting that the very method of communicating monetary policy is at a turning point.
U.S.-China Summit Diplomacy: Managed Tensions Continue
Regarding geopolitical risks, the situation has remained relatively calm recently. Following a series of U.S.-China summits held in Seoul in October 2025, Beijing in May 2026, and Washington in September 2026, the structure of ‘shaking hands on the table while stepping on each other’s feet underneath,’ which prioritizes economic practical benefits contrary to superficial confrontation, has become clear.
U.S. Treasury Secretary Bessent announced that, coinciding with President Xi Jinping’s visit to the U.S. as a state guest for the first time in 11 years, both countries agreed to extend a truce regarding trade friction. It is said that they agreed to reduce some of the tariffs imposed on each other’s imports and to temporarily suspend some of the proposed export restrictions on products including Chinese rare earths. China is proceeding with the fulfillment of its pledge to purchase 25 million tons of U.S. soybeans annually by 2028, and it is reported that half of this year’s portion has already been achieved.
However, changes in domestic political dynamics due to the U.S. midterm elections in November 2026 are considered a risk factor that requires close attention as it could affect the future stance toward China.
Sector Rotation in the Era of AI Agents
Even if the stock indices themselves do not appear to be moving significantly, rapid capital shifts between sectors by large institutional investors are underway beneath the surface. In the U.S. market, interest is spreading from concentrated investment in GPUs alone to CPUs, memory, and cybersecurity. In an era where autonomous AI operates browsers and applications, the view that demand for not only GPUs but also CPUs and memory will surge is strengthening, which is said to have led to AMD’s market capitalization exceeding $1 trillion and the rebound in Intel shares.
In the memory sector, multiple research institutions have indicated that the supply-demand tightness for DRAM and NAND will continue for several years, and capital inflows into SanDisk and Micron have been observed. Against the backdrop of concerns about the safety of AI models, cybersecurity-related stocks such as CrowdStrike and Palo Alto Networks are also said to have remained firm throughout the week.
In the Japanese market as well, it is said that buying has returned to major semiconductor and AI infrastructure-related stocks such as Kioxia Holdings, Advantest, and Tokyo Electron toward the weekend following the Bank of Japan’s decision to raise interest rates, and a concentration of short-term capital into individual stocks based on TOB and dividend increases has also been observed. In the power and defense sectors, capital is also flowing into major electric power stocks, which are valued for their cost-pass-through ability due to the revision of wheeling charges, and defense-related stocks based on the policy of raising defense spending as a percentage of GDP.
Banking Sector, Re-evaluated with Interest Rate Hikes as a Tailwind
The banking sector is what translates a high-interest-rate environment directly into improved margins and ensures portfolio stability. In one investment strategy, this is positioned as the core of an ’80/20 portfolio strategy,’ or an ‘yield anchor.’ The idea is to allocate 80% of the portfolio to stable assets such as bank stocks and bonds, whose profitability improves in tandem with rising interest rates.
Against the backdrop of rising domestic long-term interest rates, the stock prices of major banks have been performing steadily, and as symbolized by the brisk activity in government bonds for individual investors, a ‘world with interest rates’ is becoming a reality in Japan as well. The strategic value of major banks depends on how they can generate an ROE (Return on Equity) that exceeds their increased cost of capital, and it is suggested that the current interest rate environment is supporting that achievement.
In the foreign exchange market, with the dollar-yen exchange rate hovering at a nervous level of 157 to 160 yen, online discussions between Japanese and U.S. financial authorities and ‘rate check’ movements are said to function as a psychological restraint against speculative yen-selling positions. Given the history of intervention that saw a sharp drop from the high 160s to the 155 range at the end of April 2026, the structure is such that vigilance against additional intervention tends to heighten as the rate approaches 160 yen.
Structural Transformation of the Memory Market and Micron’s Strategy
Amid the demand for generative AI and the turning point of the memory cycle, the semiconductor and memory sector is positioned as an ‘alpha engine.’ The view is that the memory market is transforming from a ‘cyclical industry’ swayed by conventional economic cycles into a ‘structural growth industry’ that supports the foundation of AI infrastructure. Micron Technology has provided guidance to the company for its fourth-quarter fiscal year 2026 earnings, scheduled for release on September 30, 2026, of approximately $50 billion in revenue and a gross margin of about 86%.
Of particular note are the 16 ‘Strategic Customer Agreements (SCAs)’ already concluded, with approximately 20% of DRAM shipments and about one-third of NAND shipments fixed through long-term contracts until 2030. However, there are objections to this bullish scenario. Prominent investor Michael Burry has expressed the view that the current supply-demand tightness should not be simply extrapolated into the future, stating, ‘Production will catch up over the next two years, and the supply shortage will head toward resolution. After that, the memory market will enter a downward phase again,’ and has disclosed a short position on Micron stock.
On the other hand, Citi Securities has presented a bullish outlook that the DRAM supply shortage will worsen until 2031 against the backdrop of continuous AI learning demand, with bullish and bearish arguments coexisting in the market. Solidigm, established by SK Hynix through the acquisition of Intel’s NAND flash and SSD business for approximately $9 billion, has turned into a profit pillar due to the rapid expansion of enterprise SSD demand, and it is reported that an IPO is being considered as early as next year, with a potential valuation of up to $150 billion.
Regarding the investment trends of hyperscalers, while Microsoft has established a first-mover advantage through early infrastructure construction and rapid capital injection into OpenAI, it was revealed on September 24, 2026, that Oracle sent a ‘force majeure’ notice to developers regarding the ‘Project Jupiter’ large-scale data center under construction in New Mexico in preparation for operational delays. Its stock price fell by more than 3% on the same day, with a temporary drop of over 7% during trading hours.
Structural Challenges to Profitability Facing the AI Industry
Regarding the AI industry, a phenomenon called ‘chipflation’ has been pointed out, where the higher prices of semiconductors spill over into price increases for home appliances and automobiles. There is also a view that the rise in memory chip prices is a factor in the higher costs of smartphones and other devices, and in situations where price pass-through is difficult, a shift in demand toward cheaper alternatives may occur.
Furthermore, it is unclear to what extent the characteristics of ‘network effects’ and ‘zero marginal cost’ that have supported the growth of internet businesses apply to the business models of generative AI, which require massive capital investment. Even when viewing the AI industry in a three-layer structure of infrastructure, AI models, and applications, there is a strong view that companies handling multiple business layers are not necessarily recording sufficient profits.
From a profitability perspective, it is pointed out that the ‘law of diminishing returns,’ where additional revenue gradually decreases relative to additional investment, also applies to the AI industry, and physical constraints such as heat generation and power shortages, as well as increased costs associated with ensuring safety, are considered factors that could push down capital efficiency. The spread between the Return on Invested Capital (ROIC) and the Weighted Average Cost of Capital (WACC) of hyperscalers, the so-called ‘margin,’ was said to be over 80% in the July-September 2023 quarter, but some analysis suggests it has fallen below 3% recently due to the combination of declining capital efficiency and rising long-term interest rates.
However, according to FactSet’s aggregation, the earnings per share (EPS) for the April-June quarter for the entire S&P 500 index increased significantly compared to the same period last year, and earnings growth is expected for both the full year 2026 and 2027, leading some to believe that concerns over excessive investment by hyperscalers have receded somewhat following the earnings announcements.
Macro Indicators, Market Sentiment, and Trends in Dividends and Share Buybacks
Housing-related indicators are sluggish, with housing starts down 2.6% and permits down 2.7% from the previous month. On the other hand, there is speculation that the Atlanta Fed’s GDPNow model’s third-quarter GDP growth forecast has reached the 5% annual rate level, which, if realized, would be the highest level since the fourth quarter of 2021.
As for indicators of investor sentiment, although the Fear & Greed Index is leaning toward ‘fear,’ it has not reached a state of panic, and the VIX (volatility index) has fallen to around 14 points, which is said to reflect a sense of relief that the interest rate hikes anticipated by the FOMC have been implemented. The bullish atmosphere seen among U.S. stock investors in August receded in September, and voices anticipating an additional interest rate hike of up to 50 basis points by the end of the year are spreading due to the reignited tensions in the Middle East. The growth rate of margin trading balances has slowed from a peak of over 50% year-on-year to about 37%.
In terms of supply and demand by sector, 7 out of the 11 S&P 500 sectors are in oversold territory, with the consumer discretionary sector said to have been in an oversold state for 57 days and the utilities sector for 54 days; these are the only two sectors that have declined year-to-date. Regarding the relationship between dividends and capital expenditure, while dividends were about 20% of capital expenditure during the bull market of the late 1990s, they have now risen to nearly 50%, which is attracting attention as material indicating changes in corporate capital allocation.
Regarding dividends, GE HealthCare Technologies and T-Mobile US announced dividend increases, while AT&T and Delta Air Lines decided on dividends. It is reported that over $20 billion in demand was received for the low-rated corporate bonds in US dollars and euros planned by SoftBank Group, and the coupon rate for the 7.5-year dollar-denominated bond until maturity could reach 10%. Regarding Anthropic, there is speculation that it is in discussions to lease computing capacity from data center developers, and it is also pointed out that AI companies may consider introducing tensor processing units (TPUs) designed by Broadcom or Google.
Conclusion: A Perspective to Discern Real Demand and Margin of Safety
The background to why the stock price indices as a whole have not collapsed significantly even while interest rates remain high is ‘sector rotation,’ where funds move flexibly between specific sectors. It can be said that we have entered a phase where identifying investment targets that possess both real demand and catalysts—such as the rise in CPU and memory demand accompanying the spread of AI agents, utility companies that can pass on power costs, stocks that benefit from increased defense spending, and stocks with individual materials such as TOB or dividend increases—is more important than chasing the index as a whole.
In an interest rate environment exceeding 5%, the margin of safety lies in the spread between a company’s cash flow generation capacity and its increased cost of capital. The reliable interest margins of the banking sector and the structural pricing power of the semiconductor and memory sector form the composition that secures this spread.
Moving forward, closely monitoring changes in the Fed’s policy stance through labor market indicators such as employment statistics and the unemployment rate, as well as the ISM Manufacturing Index, is essential. Positioning market downturns caused by overreactions to economic indicators as opportunities to increase holdings of high-quality assets in banks (defensive) and semiconductors/memory (offensive) within a margin of safety is one viable solution in the current high-interest, uncertain market environment. What is required of investors is not to chase price fluctuations, but to maintain a disciplined approach in selecting areas where intrinsic value is being overlooked.