Last week saw big news in bond markets as the 10-year US Treasury yield crossed 3 per cent. It was also an important week for first-quarter corporate earnings results, with over 180 S&P 500 companies and more than 120 Stoxx 600 companies reporting, including Alphabet/Google, Facebook, Amazon, Caterpillar, Exxon, Volkswagen, Total and Shell.
At the moment, equity market valuations are caught in the middle of a tug of war between these two forces. So far, earnings season has beaten expectations, but will markets end up pricing in robust growth or the potentially negative effects of tighter financial conditions?
* Higher rates do not always mean lower valuations
Last Tuesday, the US 10-year yield exceeded 3 per cent for the first time in more than four years. The market has also raised its expectations for rate hikes from the Federal Reserve. Rising rates are a critical issue for equity valuations as they affect the discount rates applied to future earnings, and they can affect the earnings themselves by increasing funding costs and stifling corporate investment. That suggests higher rates should lead to lower valuations.
Historically, however, when the US 10-year yield has been below 5 per cent, interest rate increases have in fact been positively correlated with US stock prices and price-to-earnings multiples. This is not as counterintuitive as it seems: Rates tend to rise as the business cycle expands, when investors expect earnings to grow and sentiment is positive.
An effective Fed Funds rate at 1.5–2 per cent and a 10-year yield at 3 per cent seem an unlikely obstacle to corporate investment, particularly in light of the fiscal stimulus coming in the US. Alongside the current environment of solid economic growth, this suggests it is possible that stock prices could go up even as rates climb higher.
Nonetheless, there is a pinch point somewhere, and in this cycle it may not be as high as 5 per cent for the 10-year yield. Should the Fed hike rates meaningfully higher than expectations over the next year or two, we think equity valuations would come under enormous pressure.
* We still see momentum in earnings and the cycle
If uncertainty about rates is at one end of the rope, at the other end we have first-quarter earnings reports. In general, those reports have been strong.
It is true that analysts and investors have found reason for concern when looking past the numbers at the forward-looking commentary. Notably, shares in Caterpillar, often seen as a proxy for the state of global industry, finished down hard after a very volatile day when its report paired good first-quarter data with a warning that this might be the “high water mark” for 2018.
When investors hear that, after seeing the recent dramatic retrenchment in European economic data, they may begin to worry that the global business cycle is further advanced than they realised — and the capacity for pain-free rate hikes is much less than they thought.
Nonetheless, perspective helps here. The latest European PMIs show stabilisation, and last week’s ECB Bank Lending Survey revealed Eurozone credit easing considerably. Mario Draghi pushed the euro higher when he expressed “unchanged confidence” in meeting the ECB’s inflation target despite “a loss of momentum” in some economic data. In the US, the economic picture remains stronger still, with the latest flash PMIs supported by an upward march in consumer confidence surveys.
In short, we believe there is still momentum in this business cycle. Treasuries are not attracting safe-haven flows when equity markets are selling, signalling confidence in underlying growth and inflation expectations. This lends support to the notion that rates can rise some before they start to slow down economic activity.
Sideways trading is common in this kind of environment as investors take a few quarters to figure out where the pinch point in rates might be and whether recent earnings growth can be sustained. This tug of war between earnings and rates is something we are watching very closely.
— Joseph V. Amato is president and chief investment officer of Equities at the Neuberger Berman Group.