INSIGHTS

On May 07, 2018

AAM Viewpoints – Rising Rates Provide Headwind, Not Barrier, For Stocks

Last week’s market action was noteworthy for its flowing cross-currents. Economic and corporate earnings reports were particularly strong, but for bulls, the equity market’s reaction was disappointing. The S&P 500 Index finished the week close to flat, versus the prior week’s close. Market watchers were confounded by Tuesday’s 1.3% decline, which coincided with strong corporate earnings releases. In fact, of the 54% of Index constituents that have reported 1^st quarter 2018 (1Q18) results to date, 80% have delivered earnings per share that exceeded analysts’ expectations. That is remarkable progress! The index is now on track to deliver 23% year-over-year earnings growth for the quarter. We estimate that the new corporate tax rates may account for ~7% of the improvement, suggesting ~16% growth, pre-tax benefit. Either way, the reported, and forecasted, results represent a meaningful improvement from last year’s level, and a significant uptick in growth forecasts from the beginning of the year. In January, analysts were expecting 10.7% 1^st quarter earnings-per-share growth.

The economic data released last week painted a similarly rosy picture. Existing and new home sales, consumer sentiment, and 1Q18 GDP all came in ahead of expectations. Bond yields rose on the back of the reports, causing the U.S. 10-Year Treasury Bond Yield to pierce the psychologically important 3.0% mark. The rise in long rates may be encouraging a shift in target asset allocations in favor of bonds versus equities. The recent fund flow figures from Investment Company Institute confirm that the growing enthusiasm for equity funds, experienced at the beginning of the year, has flamed out. In fact, for the week ending 4/18, taxable bond funds saw net inflows of $9.3 billion, while domestic equity funds realized $2.4 billion of redemptions. This trend is likely to continue in the coming weeks as the Federal Reserve stays on track with its rate normalization plan, and heavy issuance from the U.S. Treasury keeps upward pressure on yields.

Source: C.J. Lawrence

As the economy improves and inflation perks up, we believe it’s likely that rising rates will exert downward pressure on the stock market’s price-to-earnings (P/E) multiple. In past cycles, that backdrop has resulted in narrowing market breadth. But analysis of previous periods with similar market conditions also suggests that these conditions do not preclude stocks from delivering attractive returns. One recent example is the 2012-2013 period, when interest rates followed a similar pattern to the one being witnessed now. Between July 2012 and September 2013, the U.S. 10-Year bond yield climbed from 1.4% at its trough to 2.97% at its peak. During that time, the S&P 500 rose 26%. In the 12 months following that peak, the index climbed another 18.5%. Technology Hardware, Semiconductors, and Internet Software and Services were the best performing groups during that period. The Commodity Chemicals, Hotels, and Metal and Glass Containers groups also performed well. The thesis of rising rates being negative for stocks is widely accepted. However, history suggests that even in the face of multiple compression and profit margin pressures, stocks can continue to rise on the back of meaningful sales and earnings growth.

CRN: 2018-0507-6653R

Opinions of this piece are that of C.J. Lawrence, LLC and are not necessarily that of AAM.