04.05.2023
Is S&P500 multiple expansion now over?
Inflation is moderating alongside falling short-end rates pricing in rate cuts over H2.
• If the fixed income market is correct, a recession is on the horizon and this is a warning for stocks.
• If the fixed income market is wrong and data remains fine, interest rate expectations would need to move higher.
• Both of these paths would put downward pressure on equity multiples, putting greater onus on earnings growth to come through, which in turn makes for a low Sharpe market backdrop.
Chairman Powell this week pointed to the strength in labour markets with no recession a more likely scenario. He reiterated that “the process of getting inflation back down to 2 percent has a long way to go,” and did not expect cuts this year. He did not rule out a June hike but said they would be now be more data dependent.
His assessment would be more consistent with the second scenario above. If his assessment is wrong, it would be because the credit crunch is intensifying and the labour market is weakening. Both scenarios put pressure on the PE multiple.
This conclusion is consistent with the observation that the S&P 500 PE multiples had contracted 8 out of the last 10 episodes after the Fed’s last rate hike and subsequent first rate cut. At that late stage of the business cycle, any further gains came from earnings growth with market introspection on the appropriate PE multiple already looking forward to what is next. The higher the Misery (inflation plus unemployment rate), the larger the PE contraction
• If the fixed income market is correct, a recession is on the horizon and this is a warning for stocks.
• If the fixed income market is wrong and data remains fine, interest rate expectations would need to move higher.
• Both of these paths would put downward pressure on equity multiples, putting greater onus on earnings growth to come through, which in turn makes for a low Sharpe market backdrop.
Chairman Powell this week pointed to the strength in labour markets with no recession a more likely scenario. He reiterated that “the process of getting inflation back down to 2 percent has a long way to go,” and did not expect cuts this year. He did not rule out a June hike but said they would be now be more data dependent.
His assessment would be more consistent with the second scenario above. If his assessment is wrong, it would be because the credit crunch is intensifying and the labour market is weakening. Both scenarios put pressure on the PE multiple.
This conclusion is consistent with the observation that the S&P 500 PE multiples had contracted 8 out of the last 10 episodes after the Fed’s last rate hike and subsequent first rate cut. At that late stage of the business cycle, any further gains came from earnings growth with market introspection on the appropriate PE multiple already looking forward to what is next. The higher the Misery (inflation plus unemployment rate), the larger the PE contraction
This should also be considered in light of the fact that the SPX 12mth fwd PE is trading close to post GFC highs and the S&P 500 equity risk premium close to post GFC lows.
On earnings, the surprising aspect of this earnings season was the ability of companies to pass on higher costs and protect their margins. On a medium term basis, one would not think that could last with falling CPI putting pressure on nominal top-lines alongside higher labour costs.
After the last hike in June 2006 we had to wait over 14mths for first rate cut in September 2007 – the backdrop was different then with earnings growth over that period exceptionally strong.
What does Qi show? SPX model value has been flatlining over the last month. It wants stronger GDP growth, tighter credit, lower rate vol and a weaker dollar.
On earnings, the surprising aspect of this earnings season was the ability of companies to pass on higher costs and protect their margins. On a medium term basis, one would not think that could last with falling CPI putting pressure on nominal top-lines alongside higher labour costs.
After the last hike in June 2006 we had to wait over 14mths for first rate cut in September 2007 – the backdrop was different then with earnings growth over that period exceptionally strong.
What does Qi show? SPX model value has been flatlining over the last month. It wants stronger GDP growth, tighter credit, lower rate vol and a weaker dollar.
With a focus on credit conditions, the senior loan officer’s survey is released on 8th May. The current US mortgage spread to 30yr yields is already indicating conditions moved tighter.
Bottom-line, the risk-reward suggests there are good reasons to respect the top of the current SPX range.
Bottom-line, the risk-reward suggests there are good reasons to respect the top of the current SPX range.
