My column last week, titled ‘Cash is king,’ showed that both cash and bonds are again competing with equities. After years of being saddled with TINA - There Is No Alternative - there again is something for investors to choose from.
Now of course those charts with duration- and risk-related ‘yields’ are nice, but it gets even more interesting when you can stick a yield on something. Below are the US 2-year interest rate (blue line right axis and vice versa) and the price-earnings ratio of the S&P 500 Index (green line left axis). You can use different variants here, for example other maturities, real interest rates, or the forward P/E ratio, they all show the same picture.
Something has to come down
As a rule, when short-term interest rates rise, the P/E ratio falls and vice versa. Especially when the interest rate rise is rapid and driven by the Federal Reserve. However, the P/E ratio has not followed the US 2-year interest rate, which rose to its highest level since 2007. This has created a yawning gap between the two variables. So either interest rates have to come down soon, or equity valuations have to come down.
I am leaning towards the latter. With the latest inflation data still on the horizon, a persistently strong labour market and the strongest drop in retail sales in two years in January, it does not seem opportune for the Fed to hint at a pivot. That means that if the two lines align perfectly, the price-earnings ratio of the S&P 500 Index should come down from 19.0 to 17.2. Assuming that earnings remain unchanged, this represents an implied price decline of almost 10 per cent. For the forward k/w, we are talking about a fall of almost 9 per cent.
Stock valuations have not come down because investors are already looking at 2024 with a slanted eye. If the much hoped-for soft landing materialises, profits could rebound sharply next year. Not a very crazy thought, except that now we have no landing at all, with additional pressure on inflation. I personally assume a delayed recession, marked by the aftermath of the Covid stimulus, which simply means it will take longer for higher interest rates to slow the economy and probably push it into recession. That does not immediately include an exuberant earnings forecast for 2024.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week appears every Monday on Investment Officer Luxembourg.