Active stock selection remains of the utmost importance, as investors should look toward attractively priced companies with strong balance sheets and resilient profits.
With this month’s softer-than-expected data on the labor market, inflation, PPI and retail sales, the U.S. 10-year Treasury yield has fallen nearly 50 basis points as the market prices out the chance of another rate hike from the Federal Reserve and brings forward rate cuts for 2024. While the Federal Reserve is now more likely to stay on hold, it is unlikely that recent data pushes the FOMC to begin cutting rates sooner, meaning investors should continue to expect a “higher-for-longer” interest rate environment in the absence of a recession. For investors, the question then becomes what does this mean for markets, specifically U.S. equities?
The fall in yields has been accompanied by a sharp rise in stocks, with the S&P 500 up 7.5% in the first half of November. However, this rise in stocks also means valuations at 18.6x are above their long-term average of 16.8x. In a prolonged higher-for-longer environment, positive real yields may begin to erode these lofty valuations. In fact, relative to historical economic and market environments, U.S. equities are expensive given real interest rates are at 2.2%. Looking at the S&P 500 forward P/E ratio and the U.S. 10-year real interest rate going back to August 1998, current real yields imply forward equity multiples are 20-30% overvalued.
However, this does not necessarily imply a massive correction is imminent. Real rates only explain part of valuations, with earnings, which have stayed resilient, also part of the equation. Earnings, in contrast to expectations, have continued to grow in 2023, and while consensus expectations of 12-13% growth in 2024 may be optimistic, we still expect earnings to grow 5-6%. Along with improving market sentiment, this should provide some support to valuations in the short-term. In addition, valuations took several years to adjust upwards to “lower-for-longer” rates after the Financial Crisis, and remained relatively reasonable until large cap technology stocks began to take off and market concentration markedly increased, distorting average valuations for the last six years.
With that being said, over time valuations may need to reset to adjust for a higher-for-longer rate environment. In such a scenario, active stock selection remains of the utmost importance, as investors should look toward attractively priced companies with strong balance sheets and resilient profits.