Federal Reserve Chair Jerome Powell’s recent speech at the Kansas City Fed’s annual symposium failed to provide a clear resolution to the ongoing market conflict regarding the impact of rising interest rates on the 2023 stock-market rally. While Powell acknowledged the persistence of high inflation and expressed the Fed’s openness to raising rates again if necessary, his remarks hinted at the possibility of sustained high interest rates. This scenario could elevate borrowing costs, placing pressure on stocks as investors discount the future value of corporate earnings.
Although Powell’s message resembled his previous statements, it disappointed portfolio managers who were hopeful that the rapid rate cycle might conclude. Despite a modest stock market rise following the speech, futures markets indicated a growing expectation of prolonged higher interest rates. Elevated yields in bonds tend to diminish the appeal of risky investments like stocks by offering attractive alternatives in the market.
The dilemma lies in determining when the bond market becomes a competitive choice for investors compared to stocks. The current year has been challenging for investors in riskier assets, as strong signs of the U.S. economy’s resilience, increased Treasury debt sales, and the prospect of prolonged high rates have led to higher government bond yields. Market traders now predict a higher likelihood of the central bank implementing further rate hikes by year-end, and they foresee a decreased chance of rate cuts by next June.
Amid these uncertainties, investors are closely examining indicators like the Fed’s preferred inflation gauge and monthly jobs reports, along with earnings reports from major companies such as Best Buy, Salesforce, and Dollar General. This evolving scenario coincides with indications that the AI trade’s momentum is waning. Even robust forecasts and impressive sales figures from AI-focused companies like Nvidia failed to ignite a broad market rally, possibly suggesting that positive earnings projections are already priced into shares.
The recent surge in long-term bond yields has amplified concerns that the stock market is trading at high valuations, potentially making it susceptible to adverse news. While enthusiasm for AI and growing economic confidence have driven stock prices up, forecasts for corporate earnings have seen more modest increases. This has led to a perception that the market is richly valued in historical context.
Rising long-term interest rates are particularly significant as they offer investors alternative avenues for returns, contrasting with a prolonged period of low rates where stocks were seemingly the primary choice. Higher rates also erode the future value of earnings in common pricing models. Consequently, stocks could trade at lower earnings multiples if the market embraces reduced valuations in response to increased interest rates and real yields.
The broader stock index’s valuation stands at 18.6 times projected earnings for the next year, up from 16.6 at the year’s outset and surpassing the 20-year average of 15.8. This valuation has prompted concerns, with analysts questioning the justification for such high multiples in a scenario of 2% real yields. Overall, the interplay between rising interest rates, real yields, and stock valuations is forcing investors to reassess their strategies, acknowledging the mathematical relationship between increased cost of capital and decreased valuation multiples.
(Source: Karen Langley | WSJ)
