Stocks are concerned about rates again.

That’s according to Morgan Stanley’s Mike Wilson. Mike’s a bear, generally speaking. Spare a thought.

Wilson’s latest trod familiar territory. For weeks, he’s argued the veritable chasm which opened up this year between equities and rates might eventually “resolve” in lower stocks or at least in multiple compression. The moment for such a resolution might be nigh, he suggested on Monday.

The five-month equity rally (one of the most pronounced in recent memory) was due almost entirely to valuation expansion. That dynamic should’ve paused in 2024 as expectations for Fed cuts were trimmed aggressively. Instead it just kept on going, in part due to AI optimism.

Last week, in the wake of a third consecutive US CPI overshoot, pricing for 2024 Fed cuts receded below 50bps, the front-end sold off aggressively and 10-year yields broke above 4.50% for the first time since November.

“Assuming much of the rise in equity valuations since October was a function of lower rates, it’s reasonable to assume that these same valuations may now face headwinds if rates rise further,” Wilson said.

I’d gently note that equities — and particularly equity multiples — aren’t exactly famous for being “reasonable.”

Another problem (i.e., in addition to stocks’ penchant for irrationality) is that in a rates selloff, it’s often not the level that matters for stocks but the rapidity of the move. Wilson conceded as much on Monday.

“While the level of rates suggests valuations are rich, the more statistically sound approach is to look at this relationship in rate of change terms,” he said. As it turns out, a simple regression suggests multiples are “actually” (Wilson’s surprise) fairly valued on that score.

The table on the right gives you a (stylized) idea of what’s fair for multiples in different rate of change scenarios for benchmark US yields. If the 10-year sells off further to 5% (i.e., October’s cycle high), the S&P’s multiple would compress to 18x, all else equal.

Wilson also noted that history suggests multiples re-rate ahead of realized earnings inflections and de-rate “once the stronger earnings arrive” in a kind of sell-the-news phenomenon. That pattern’s observable in mid-to-late cycle growth re-accelerations,” he said.

That needn’t be a death knell for the rally, but it does mean that in order for stocks to keep moving higher, estimates would have to “continue to increase at a faster rate” in order to “offset multiple compression.” Maybe that’s possible for some names, but not for all of them, Wilson said, which points to more dispersion.

The upshot, Wilson wrote, is that considering “the recent increase in rate sensitivity for equities, a further rise in yields from here can lead to a normalization of P/E multiples.” That’s one, but not the only, “consequence [of] the shift in the macro view from ‘soft landing’ to ‘no landing.'”