A near constant theme in these pages — a perpetual topic du jour, if you’ll pardon the paradox — is the notion that rising real rates are kryptonite for richly valued equities.
So far, that’s the story of 2022’s bear market. Until profits are finally blown off course by gale-force margin headwinds and forward estimates undercut by the vicious macro undertow, we’re compelled to explain this year’s losses by way of higher rates. It’s a valuation compression story.
You could easily suggest that leg of the selloff is complete. Or mostly complete, anyway. Indeed, many bears argue just that. “Like us, most equity clients feel like the Fed is largely priced into multiples,” Morgan Stanley’s Mike Wilson, among the most bearish top-down strategists on Wall Street, said last week. “We remain laser focused on earnings as the key driver of stocks from here,” he went on to write, in the same note. “While the Fed is important, it will likely not be the main driver of stocks on either the downside or the upside given the narrow path of options it has, in our view.”
That may be true, but as we’ve seen over the past several days, there’s still scope for equities to sell off on policy concerns, and, relatedly, for stocks to respond to higher real yields.
The figure (above) gives you some context. Note that the summer rebound in equities was accompanied by a large drop in reals. The subsequent surge in real rates is now catching up to stocks.
If valuations do contract anew in the face of tighter financial conditions, it suggests a sort of double jeopardy scenario — more comeuppance for egregious valuations seen just prior to the onset of the bear market, but also a reality check for more recent sins. Recall that over the three-week selloff which included Jerome Powell’s speech in Jackson Hole, multiples stubbornly refused to surrender the entirety of the re-rating seen during the summer rally. Small wonder the bottom fell out following the unfavorable core CPI print.
“For equity investors, [the] inflation print stoked concerns about the outlook for valuations,” Goldman’s David Kostin said. “Equity valuations have closely tracked the path of interest rates during recent years [and] the real 10-year US Treasury yield has risen from -1% at the start of 2022 to +1% today,” he remarked. “In the face of inflation, rising interest rates and more Fed tightening, equity valuations likely face further downside.”
Note that the more stretched valuations are at the outset, the more vulnerable stocks are. “Starting valuations matter,” SocGen’s Jitesh Kumar wrote, in a recent note juxtaposing 2022 to the taper tantrum (figure below) on the way to suggesting multiples can contract further.
“In 2013, [the] Shiller P/E was around 20x. In November 2021, it was close to double the level,” Kumar said. “Looking at the data from the past 25 years, overall valuations still seem elevated for the current level of real rates.”
But going forward, it won’t be just a rates story. Although Q2 earnings season was “better” than expected thanks in part to a lowered bar, it felt like an exercise in can-kicking. The profit reckoning foretold by a handful of top-down strategists looks imminent. FedEx might’ve been the “Wile E. Coyote moment” for those clinging to the notion that earnings somehow won’t succumb.
“From a fundamental perspective, firm inflation also increases the risks facing profit margins,” Goldman’s Kostin said late Friday. He cited FedEx’s pre-announcement.
Goldman expects net margins to contract by 25bps next year, but reiterated that “in a recessionary scenario we would expect profit margins to fall by 126bps.” Also on Friday evening, Goldman’s economists cut their outlook for the US economy and slightly lifted their subjective recession odds.
Note that consensus still expects S&P 500 margins to climb by 14bps in 2023 to 12.4%. That’d be a record high.