Traders work on the floor of the New York Stock Exchange (NYSE) on Jan. 31.Spencer Platt/Getty Images
One curiosity to emerge from the seismic shift in U.S. interest rate expectations in recent weeks is equity strategists’ reluctance to lower their year-end forecasts for U.S. stocks.
From the relative bulls at BNP Paribas, to the relative bears at Bank of America, nobody has downgraded their outlook for Wall Street even though money markets now expect at least five quarter-point rate hikes from the Federal Reserve this year.
Bear in mind that when banks published their 2022 year-ahead brochures late last year, barely 50 basis points of tightening was priced in, liftoff was not expected until the second half of the year, and the real 10-year Treasury yield was below -1 per cent.
Some economists - such as those at Morgan Stanley - didn’t expect the Fed to hike rates at all this year. But every Fed meeting now is “live,” and U.S. stocks have had one of the most volatile starts to a year ever.
Yet the prevailing mood is “stay calm and buy the dip.”
Take Bank of America, whose economists last week issued the most aggressive Fed forecast to date: seven quarter-percentage point hikes this year, four more next year, and the fed funds rate peaking at 2.75 per cent to 3.00 per cent.
That’s significantly more hawkish than their outlook late last year of three rate hikes in 2022. Then, BofA’s equity strategists’ 2022 price target for the S&P 500 was 4,600. Their price target today? Still 4,600.
At BNP Paribas, the U.S. equity strategy team had 5,100 penciled in as their end-2022 forecast at the same time their economics colleagues were predicting three Fed rate hikes of 25 basis points each.
The bank’s Fed call is now for six rate hikes, and the S&P 500 target is still 5,100.
Higher interest rates should be a drag on stocks as they raise the cost of borrowing for firms. They also have the mechanical effect of raising the discount rate used to value future cash flows in today’s share prices - particularly for many tech stocks and small caps.
REAL YIELD & MULTIPLES
So what gives?
On the macro front, recession still seems a distant prospect even though growth forecasts are dimming, and flattening pressures are persisting across the Treasury yield curve. As long as the economy grows at a reasonable pace - comfortably north of 3 per cent is the consensus - corporate profits should hold up.
Greg Boutle at BNP Paribas remains confident that Corporate America can post double-digit earnings growth this year - double the consensus of around 8 per cent - which will offset headwinds from tighter financial conditions.
He estimates that a 25 basis point rise in the 10-year real yield is equivalent to a fall of around 1.1 in U.S. price-to-earnings ratios. At one stage last week P/E ratios had compressed by around 2.2, consistent with a trough-to-peak rise in the real yield of around 50 basis points.
Real yields have slipped back a bit, but Mr. Boutle argues that the downturn in January - the S&P 500 was down more than 10 per cent and the Nasdaq almost 20 per cent at one point - is nothing to be alarmed about. The S&P 500 jumped almost 2 per cent on Monday to end the month at 4,515 points.
“The market’s Fed pricing injects the potential for a little bit more turbulence, or headwinds to our view, but markets are efficient and forward looking,” he said.
BUY AT 10% OFF HIGHS?
Basing his calculations on Friday’s close around 4,432 points and the 10-year real yield at -0.60 per cent, David Kostin at Goldman Sachs estimates that, all else equal, the S&P 500 would decline by 10 per cent to 4000 if the yield rose 60 basis points to 0 per cent, and by 15 per cent to 3,800 if it rose by 100 bps.
But Mr. Kostin also says history shows buying the S&P 500 10 per cent off its high generates a median return of 15 per cent over the next year. Translated to today, that puts the index up at 4,975.
“Market corrections are typically good buying opportunities if the economy is not entering into recession,” Mr. Kostin observes.
Investors have fourth-quarter earnings to digest just now, and with a third of them in, 78 per cent have beat forecasts.
On balance, Fed officials are still displaying their new-found zeal to tighten financial conditions rather than push back against current market pricing. Equities are hanging in, just.
Another reason equity strategists are holding the line may be they simply don’t agree with their rates colleagues. Or, as JP Morgan’s Marko Kolanovic and team put it in a note on Monday, they think current rates market pricing is too aggressive.
“Our economists now forecast five hikes in 2022, but we think the risk is that inflation-related data improve and fewer hikes are ultimately delivered,” they said.
Now that would be bullish for stocks.
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