The viability of the current early-year stock market rally may hinge on whether equities can withstand a potential increase in interest rates. The year began with a reversal in investors’ mood, from widespread pessimism about a pending recession at the end of 2022 to optimism for a soft landing for the economy, predicated on better-than-expected economic data. Stocks rallied in January as investors discounted the risks of a deep recession, a Federal Reserve policy mistake, and the potential for accelerating inflation.
In addition, with the Q4 earnings season underway, the market has already priced in shrinking corporate profits, which would be a tailwind for the bulls. So far in the current earnings season, companies are reporting Q4 earnings that are, on average, 1.1% above expectations, below the one-year average surprise rate of 4.5%. The market’s reaction to earnings misses has been better than average too. The recent bullish optimism doesn’t mean that investors should be complacent, particularly given the uncertainty over how long the Federal Reserve may keep monetary policy restrictive. Rates might rise and stay higher for longer, challenging the current lofty valuations for equities.
In the view of some market analysts, the decline in yields in recent weeks has provided crucial support for the current rally but also highlights a key risk for market participants should interest rates turn higher. Stronger-than-expected economic data in the coming months could force the Fed to maintain its restrictive monetary policy stance for longer. In recent comments, Fed Chair Jerome Powell stated the potential peril of complacency regarding disinflation. “I think there has been an expectation that inflation will go away quickly and painlessly, and I don’t think that’s guaranteed. That’s not the base case.” As the accompanying chart illustrates, the S&P 500® Index price-to-earnings (P/E) ratio of 18-times forward earnings might be at risk if interest rates suddenly begin to rise.
However, looking at valuations among equity sizes and styles can give us a more holistic view of the current market picture. Valuations for growth stocks appear elevated relative to the stock benchmark, with the forward P/E of the Russell 1000 Growth® Index (representing the most significant growth stocks in the market) sitting at 24-times the next 12-month earnings. In comparison, the Russell 1000 Value® Index is more attractively priced with a forward P/E of 15-times earnings. Small-caps and international stocks appear more attractively valued, with forward P/Es of 14-times earnings for the S&P SmallCap 600® Index and 13-times earnings for the MSCI EAFE® Index.
Interest rates, global central banking policy shifts, and earnings quality can explain some differences between the multiples. For example, value stocks are typically less sensitive to interest rate changes, and small caps have done well historically in inflationary environments. Similarly, the current P/E of 13x for the MSCI EAFE Index is approximately 10% below its 10-year average of 14.3-times earnings. Many investors are excited about the international markets due to resilience in Europe and the reopening of the Chinese economy. As equity markets flirt with their highest levels since last August, investors shouldn’t assume that volatility is a relic of 2022. Pay attention to the direction interest rates take in the coming weeks, and be mindful of the relative performance of different stock indexes.