In bull markets, valuation generally doesn`t matter very much unless it reaches a nosebleed extreme, such as the NASDAQ Bubble. In bear markets, valuation defines the downside risk in equity prices.
As the Powell Fed has signaled it is dead set on a hawkish policy that does not preclude inducing a recession, valuation will matter soon. The 10-year Treasury yield stands at 2.8% and the S&P 500 forward P/E is 19.0. The last time the 10-year reached these levels was 2028 when the forward P/E traded mostly in a range of 15-16 but bottomed at a panic low of 13.6. The previous episode of a similar 10-year yield was in H2 2013 when the forward P/E was in the range of 13.5-15.
All else being equal, this implies downside risk of -15% to -30% for the S&P 500. That’s why US equity investors are playing with fire.
The Fed’s inflation obsession
Inflation and inflationary expectations are why the Fed has turned so hawkish. The March core CPI report came in at 0.3%, which is well below Street expectations of 0.5%. The bad news is that services CPI has been accelerating for several months. As goods inflation ease from a combination of base effects and the easing of COVID-related supply chain shortages, consumers have shifted spending from goods to services. An acceleration in services CPI is an unwelcome development for Fed officials.
The Fed is well aware of these changes. New York Fed President John Williams stated in a Bloomberg interview
: “We are seeing signs that consumers are shifting their pattern from goods to services … It is a pattern I expect to continue, and it is an important part of the story as we watch consumers move back to more normal patterns of spending.”
While core CPI was weaker than expected, PPI came in hot and well ahead of expectations at an astonishing 11.2%. The key question is how well companies will be able pass on these rising input costs to their customers, the effects of the pass-through on corporate margins, and the leakage effects of higher commodity prices on CPI.
While inflation will eventually come under control, the risk for the Powell Fed is that inflationary expectations become unanchored. Already, they have reached a new high for the current expansion, though levels are consistent with readings seen in past cycles.
As a consequence, the market is now discounting consecutive half-point rate at the next three FOMC meetings, followed by a staccato series of quarter-point every meeting until February 2023. Fed Funds are expected to reach the Fed’s long run neutral rate of 2.4% by the November meeting and well exceed the Fed’s projected peak rate of 2.8%, according to the Summary of Economic Projections.
More valuation headwinds
In a rising rates environment, earnings growth and estimate revisions are left to do the heavy lifting for equity prices. So far, forward 12-month EPS estimate revisions are still rising, which is a positive.
However, there is more to earnings growth than meets the eye. Jurrien Timmer
at Fidelity pointed out that S&P 500 Q1 EPS growth is reported to be 5.1% but all of the gains are attributable to higher oil and gas prices. Q1 EPS growth falls to -0.1% if the energy sector (3.9% of S&P 500 weight) is excluded.
A slowing economy
Q1 earnings season could be a problem. Corporate guidance has turned negative. While EPS beat rates could still be positive as management plays the beat the Street expectations game, the challenge is to maintain a positive tone when discussing the outlook for the remainder of 2022.
As well, top-down indicators point to a slowing economy, which may also create headwinds for earnings expectations for the remainder of 2022. The Citigroup Economic Surprise Index, which measures whether high-frequency economic releases are beating or missing expectations, could be starting to stall.
Job postings on Indeed have plateaued and begun to roll over. When will the deceleration in job gains begin to show up in the Non-Farm Payroll reports?
In the fourth week of March, the Weekly Index of Retail Trade decreased 0.1% on a seasonally adjusted basis after remaining unchanged in the previous week. For the month of March, retail & food services sales excluding motor vehicles & parts (ex. auto) are projected to decrease 2.9% from February on a seasonally adjusted basis and to decrease 4.2% when adjusted for inflation.
From a global perspective, China’s zero-COVID induced lockdowns are concerns for global growth. Gavekal
reported that in its survey of the top 100 Chinese cities, all but 13 have imposed some form of quarantine restriction, from no restrictions (level 0) to full lockdown (level 4). More importantly, lockdown intensity is increasing.
High frequency data shows a slowdown in the Chinese economy and the world faces two China shocks. The first is from falling demand from its zero COVID policy, and the second is from a supply shock owing to a slowdown in Chinese production. Neither are growth-friendly and neither will be positive for the corporate earnings.
How long can US equity prices defy valuation risk? One hint can be found in the latest BoA Global Fund Manager Survey, which found that global institutions regard the US as a safe haven. In the short run, positive fund flows can partially support the S&P 500.
Before the bulls get too excited, the same survey found that managers believe S&P 500 downside risk is greater than upside potential. As a frame of reference, the survey was conducted April 1 to 7, when the S&P 500 traded in a range of 4500-4540.
In conclusion, the S&P 500 is facing the twin macro risks of a hawkish Fed and deteriorating fundamentals. Based on the current 10-year yield of 2.8% and the current earnings outlook, the historical downside risk is between -10% and -30%. Arguably, the 10-year yield should be much higher in light of recent core CPI readings, which would have even greater dire consequences for equity valuation.