U.S. stock market indexes turned in the worst first half of the year since 1970. During the second quarter, the selloff intensified as overall sentiment became extremely negative and fear of Fed-induced recession spread. The S&P 500 finished June down nearly 20% year-to-date, which is difficult enough, but many stocks have fallen much more than that. After 14 years of holding rates near zero, including a two-year COVID delay, the Fed got serious about fighting inflation, and asset prices have adjusted.
As we said last quarter, some of this “revaluation” is rational. Higher interest rates suggest lower overall valuations simply because future profits and cash flows are not worth as much today if they’re being discounted using a higher rate. It’s just math. However, the valuation level that is fair depends largely on the so-called terminal rate, or how high the Fed Funds Rate goes during this tightening cycle, and no one knows that today. This is why it’s difficult to say whether the bear market (for most stocks) has gone far enough (or too far) in revaluing stocks to reflect a higher interest rate paradigm.
The other valuation unknown is the E(arnings) in P/E. Each company operates differently throughout the economic cycle, but generally when the economy is contracting, it’s more difficult to increase profitability. For the most part, March and June quarterly earnings announcements have been strong. However, as you might expect during such a period of negativity and pessimism, executives are seizing the opportunity to lower expectations going forward. To the extent future results miss estimates, those stocks could see additional pressure. On the other hand, the average stock has fallen a lot, so quite a lot of pessimism is priced in.
It is certainly possible that to adequately slay inflation the Fed must raise rates to a level that causes a recession, but that is still not our forecast. Our view is based on the fact that markets have already done much of the Fed’s work – close to 300 basis points of tightening are already reflected in mortgage and other lending rates. Long before the Fed tightens three or four or five more times, Chair Powell and the Committee will see real-time data on prices and behavior based on higher rates. Already, oil and copper prices are down 20% from recent peaks. Lumber prices are down more than 50%. Even agricultural products like wheat, corn and soybeans (that you might expect to stay high due to the ongoing war in Ukraine) have fallen considerably. The Fed calls itself “data dependent,” and these are the sort of data that might help it avoid mistakes causing a severe recession.