Stocks remain under pressure, and we see two major causes for this. The first is that valuation is compressing as interest rates move higher. The second is that higher interest rates could ultimately slow the economy to the point of recession, which would result in lower corporate profits. These sources of volatility are discussed below.
The consensus forward price-to-earnings (P/E) multiple is a closely watched market valuation parameter. Bond yields also play an important role in stock market valuation. Low bond yields imply higher valuation since future stock cash flows are worth more in today’s dollars. Conversely, high bond yields imply lower valuation since future cash flows are worth less in a high interest rate (high inflation) environment.
In the aftermath of the 2008 Great Recession, the market’s forward P/E fell to close to 10, reflecting significant uncertainty in the aftermath of the crisis. It slowly but surely climbed through the last decade up to about 18 prior to the pandemic. Bond yields remained low during this period as inflation also remained low.
As the economy was reopening earlier in the pandemic, the forward P/E spiked to as high as 24 while bond yields were at historic lows of around 1% given significant uncertainty surrounding the pandemic. This high P/E embedded the historically low interest rates and the promise of pent-up demand supported by unprecedented fiscal stimulus. There was also significant uncertainty around future earnings, which in hindsight, proved way too conservative as earnings rose much faster than anticipated.
Even with the P/E compressing from 24 to closer to 22 by late 2021, stocks powered higher, supported by earnings that continued to come in much better than expected. With the economy beginning to overheat, the Federal Reserve moved from a highly accommodative interest rate policy and started raising short-term interest rates to cool the economy this year. Longer-term bond yields rose in sympathy with this less accommodative Fed policy with longer-term interest rates now off the historic lows and around 3% today.
Given higher bond yields imply lower valuation, we have indeed seen valuation compression, especially for highly valued stocks. The consensus forward P/E multiple has declined from 21x at the start of 2022 to 16.5x today, tracking closely the rise in interest rates, even as earnings estimates for 2022 moved higher. The market is now more reasonably priced, trading below its 25-year average valuation level of 16.9.
We continue to place a low probability on a near-term recession which would cause a significant falloff in profits. Last week’s readings on April retail sales and industrial production add to other recent important indicators that suggest sturdy economic demand drivers.
While the increase in retail sales in April was the smallest this year, it was still more than double the average April gain since 1990, prior to the pandemic. This suggests unwavering consumer strength despite the end of fiscal stimulus last year and surging inflation.
Industrial production increased 1.1% in April, the most in six months, and more than double the consensus of 0.5%. On a y/y basis, production was up 6.4%, much stronger than the 1.7% gain per annum in the previous expansion, and more than double the 3.1% gain per annum historically since the 1940s. This considerable strength supports a positive outlook for capital expenditure growth and the broad economic expansion.
We also note that leading indicators for inflation suggest easing inflation pressures in the coming months that could make the Federal Reserve’s job of rate hikes easier. Goods demand, supported by massive fiscal stimulus, surged last year and was a major driver of inflation. We are now seeing goods demand moderate while service activity is returning to normal as the pandemic fades. Goods inventories are now well above pre-pandemic trend levels which suggests lower future price pressures.
Despite China COVID lockdowns and the Ukraine war, supply-chain bottlenecks show signs of easing. There are signs wage inflation may be starting to ease while there is room for the labor force participation rate to improve. Importantly, longer-term inflation expectations remain contained, which makes a soft landing more likely.
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