Valuations recalibrate: Coming into the year, equity valuations were supported by still-low interest rates. Ten-year Treasury yields sat just above the 1.5% mark, while 2-year yields were just 73 bps. Then the hard reality of persistent inflation and aggressive Fed tightening sunk in, taking 10-year yields to near 3.5% at one point, and 2s north of 3% in anticipation of further rate hikes. This seriously repriced equities, especially higher-growth areas that are more reliant on future earnings. The forward price-to-earnings ratio on the S&P 500 has fallen to just below 16, a 6-point compression since last fall. Looked at another way, the forward earnings yield has risen from around 4.5% to 6.3% at last check. If you’re really following closely, you’ll see that the 180 bp widening of the earnings yield roughly matches the move in 10-year Treasury over the same period. So, stocks haven’t necessarily become cheap, they’ve just been revalued against the new interest rate backdrop. And, this is consistent with a repricing of various other asset classes currently underway (see real estate, for example).
All eyes on earnings: With that in mind, the next real test is how earnings hold up into 2023. Expectations to this point have held firm, with calendar-2022 growth in S&P 500 profits currently expected at just under 10%, compared to around 9% coming into the year (Refinitiv’s bottom-up tally). While calendar-2023 has faded slightly since the spring, that is impressive stability considering the big moves in stock prices. This just reiterates that valuations and Fed policy have been driving the moves, at least for now. Looking ahead, we see economic growth slowing to a standstill around the turn of the year, which should be a headwind to profit growth. At the same time, the strong U.S. dollar, flat yield curve and rising unit labour costs are all earnings headwinds. But, inflation (to the extent firms can pass on price increases rather than getting margins squeezed), should support nominal earnings numbers. As we start to see earnings reports and guidance roll out of the next few weeks, the level of resilience on that front will be key in dictating where stocks go from here, along with the evolution of inflation trends.