Fed rate hikes: Cause for pause?
Fed watchers see potential for a pause in rate increases, but recent reports show the economy still runs hot.
A notable shift has occurred in the capital markets over the past year with interest rates moving steadily higher and equity market valuations coming down from their peaks.
Higher interest rates are a headwind to valuations for several reasons, such as their impact on earnings, discount rates applied to future earnings, and competition for investor funds with bond funds now providing a more attractive yield. Since the 10-year Treasury yield hit the unimaginable low of 0.54% on July 31, 2020, the yield has jumped by 2.41 percentage points to 2.95% this week. During the same stretch, the forward price/earnings (P/E) multiple for the S&P 500® Index declined from 21.9-times forward earnings to the current level of 18.7-times.
This pain is particularly evident in certain pockets in the technology space, where stocks are expensive when measured on traditional valuation metrics most of the value comes from earnings that are many years away. The Russell 1000 Growth Index has seen its valuation decline from 33.4-times forward earnings in September 2020 to 24.9-times currently. The so-called FAANG group (Facebook, Apple, Amazon, Netflix, and Google) have seen its price/earnings ratio nearly cut in half, from a peak of 52-times forward earnings to 27-times currently. This is a notable shift in leadership, but consistent with the transition in the business cycle.
This relationship presents a unique challenge for investors. Typically, bonds act as a ballast against equity market volatility, providing the benefit of diversification. Since 1975, the S&P 500® Index has seen eighty calendar-year declines and the Bloomberg U.S. Aggregate Bond Index has been negative in four calendar years, but both benchmarks have never been negative in the same calendar year. Through April 21, the S&P 500 has returned -7.4%, and the Bloomberg bond index has returned -9.3%, which puts that index on track for its weakest calendar year on record. If rising rates continue and put additional pressure on equity valuations, investor returns are likely to suffer.
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Bloomberg US Aggregate Bond Index: An unmanaged, market value-weighted index of U.S. dollar-denominated, investment-grade, fixed-rate, taxable debt issues, which includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities and commercial mortgage-backed securities (agency and non-agency).
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