Equity investors may be underestimating the potential consequences of a miscalculation of the Federal Reserve interest rate path. The market is already pricing in a Goldilocks scenario of stable economic growth and low inflation. It could be a costly misjudgment.
While the S&P500 has increased by over 8 percent this year, even with banking sector problems in March, bullish investors may be further emboldened by windfall quarterly earnings this month. CNN’s Fear and Greed Index currently sits at 68 points on the greed side. That reflects the current consensus: equity investors expect a stable economic environment with moderate growth and low inflation, or a Goldilocks scenario or soft landing.
A pivot makes money
Despite Fed Chairman Jerome Powell’s assurance that a rate cut is not yet in the cards, investors are pushing back. Market experts expect the Fed will increase interest rates once or twice more, but will cut them by 50 basis points to below 5 percent before the end of 2023. This projected scenario has buoyed investor confidence.
Historically, high interest rates have benefited S&P500 investors, earning them an average of 19 percent in the 12 months following the peak since 1982, according to a market report by Goldman Sachs. The study analyzed six Fed tightening cycles over that period, and shares rose after all but one cycle.
That’s reason for optimism, one might say. Whether that is justified depends entirely on whether central banks manage a soft landing.
A hard landing
The opposite scenario, where overly tight monetary policy causes a recession is usually a painful situation for equity investors: high unemployment, falling asset prices, and less economic activity.
Starting with the Great Depression, the S&P500 has experienced maximum drawdowns of 14 to 57 percent during periods of recession, according to research by Lori Calvasina, strategist at RBC Capital Markets. The average recession drawdown of the S&P 500 is 32 percent, Calvasina said. Typically, the damage recovers within a year to a year and a half.
For the US, most recession rate gauges expect a 60 to 95 percent chance that real economic growth will be negative within 12 months. Last month, the yield curve of US Treasuries reached the deepest inversion in more than 40 years, a time-tested indication of an upcoming recession with implications for valuations.
P/E ratio will fall
Richard Abma, CIO of asset manager OHV Vermogensbeheer, said market participants should be wary of “multiple compression”, where falling P/E ratios occur as investors become more cautious and demand higher returns on their investments.
Currently, the average price-earnings ratio of the S&P500 is just above 22, while the mean ratio is 17. Abma warns that the risk is high that multiples will move back to the mean, especially with concerns about key macroeconomic data known as “leading indicators.”
A number of U.S. leading indicators “are sounding the alarm right now,” Abma said. “Insider selling is spiking, and the number of jobs available in the U.S. is falling.”
The latter indicator is important because the job engine keeps the U.S. economy running well. With rising unemployment due to high interest rates and tightening liquidity, equity markets will start to react negatively. According to Abma, there is a “good chance” that the weekly unemployment figures will soon start rising sharply.
Two risk scenarios
Joost van Leenders, investment strategist at Van Lanschot Kempen, also considers a scenario in which inflation falls and interest rates can be lowered without significant damage to the economy “less likely”. In his view, U.S. equities are priced too optimistically.
“For equity markets, we see two risks,” said Van Leenders. “The first is that growth and inflation cool further as a result of tightening monetary policy. Central banks may start cutting interest rates in that case, but then there will also be more pressure on earnings. Any downward earnings revisions are negative for equities.”
“The second scenario is that the economy does not cool sufficiently for interest rates to be cut. In that case, interest rates will continue to rise, which could also be negative for equities.” Growth stocks in particular - which have accounted for much of the rally in the U.S. - will be hit hard, according to Van Leenders.
Europe
“A later post-pandemic reopening and easing of banking stress potentially means greater resilience in Europe relative to the U.S., raising the bar for recession here,” said Konstantin Veit, portfolio manager at US bond house Pimco, asked about the risks to European equity markets.
“Granted, if the U.S. starts to contract, the Eurozone will not be immune. But if the U.S. recession turns out to be as mild as we expect, it is not inconceivable that Europe will get away with stagnation,” Veit said.
This article originally appeared in Dutch on InvestmentOfficer.nl.