Despite a week devoid of inflation catalysts, markets are still struggling to determine whether or not the newer narrative (inflation and Fed policy) will derail the older one (above-trend growth and earnings). Inflation worries and rising rates were among several factors that jolted equity markets out of complacency earlier this month. Yet equities have largely looked through the upside surprise in core CPI two weeks ago, which increased at the fastest pace in 12 years. Furthermore, if this rebound in inflation continues, it will continue alongside quarterly Fed hikes. A key question going forward is how risk assets will digest these developments over the coming months.
In theory, higher rates should negatively impact equity profits and valuation multiples for three main reasons: 1) rising interest expense hurts corporate profits (S&P 500 total debt ex financials stands at ~$5 trillion); 2) a higher discount rate reduces the net present value of future earnings (from a DCF perspective); and 3) declining relative valuation support (income investors rotate as bond yields compete with dividend yield). However this is a gradual process and periods of rising interest rates have actually coincided with positive stock returns close to 90% of the time. In fact, the best year was 2013, during which the S&P 500 returned 32% despite the 126bp rise in the yield on the 10Y Treasury (see graph below).
That being said, we may be getting closer to exiting the “sweet spot.” Historically, the probability of loss for the S&P 500 increases when the 10-year Treasury yield rises above 3%, with the best S&P 500 returns occurring when the 10-yr Treasury yield has ranged from 2%-3%, particularly when yields have been rising.
While rising long-term rates will ultimately become a negative for profits and multiples, current levels probably don’t warrant de-risking and selling equities. Fundamentals remain strong, expansionary fiscal policy should provide a further boost, and global central banks remain supportive. However, if inflation rises more quickly than expected, concerns over Fed policy would probably dominate markets, even if activity and earnings data continue to evidence above-trend growth. The reason is that faster inflation accelerates endgame thinking around the business cycle, and investors are not positioned for a possible 2019 end to the expansion if Fed policy has to turn restrictive next year (Fed funds futures are only pricing in four hikes between now and the end of 2019).
My Top 10 Reads of the Week:
- MIT Technology Review: 10 Breakthrough Technologies 2018
- MIT Technology Review: A Smarter Smart City
- WSJ: How Jeffrey Immelt’s ‘Success Theater’ Masked the Rot at GE
- Wired: Crispr Gene Editing Will Transform How We Eradicate Invasive Species
- MIT Technology Review: The “Black Mirror” Scenarios That Are Leading Some Experts to Call for More Secrecy on AI
- WSJ: The Risk Pension Funds Can’t Escape
- MIT Technology Review: The Carbon-Capture Era May Finally Be Starting
- The Economist: License to Kill Competition
- The Economist: How Does Chinese Tech Stack Up Against American Tech?
- WSJ: Dollar-Rate Breakdown Exposes Foreign-Exchange Mystery