Written by:  Mutsumi Kagawa (Chief Global Strategist, Economic Research Institute of Rakuten Securities)

(30/09/2022)

1. Rising long-term interest rates push US stocks to new year-to-date lows

The triple shock (Jackson Hole shock, CPI shock and FOMC shock) since the end of August caused the long-term interest rate (10-year bond yield) to rise to more than 4% this week. The S&P500 index and the NY Dow Jones Industrial Average fell below the year-to-date lows set in mid-June and were forced to enter a bear market again. As US bonds continue to fall, short-term interest rate (2-year bond yields) which is sensitive to trends in policy interest rates and long-term interest rate continue to reverse (inverted yields). Speculation of future economic downturn also causes anxiety for stocks. Chart 1 shows the S&P500 index and the “fear index” (VIX = CBOE S&P500 Volatility Index) over the past year. Being wary of the 3rd consecutive interest rate hike (0.75%) determined at last week’s FOMC (Federal Open Market Committee) and the latest economic and interest rate forecasts, there is a growing fear that the cumulative effect of monetary tightening will worsen the real economy and corporate earnings. The “fear index” exceeded 32 points at one point this week, indicating a growing sense of uncertainty about the future (September 27). However, on September 28, US long-term interest rates fell to the 3.7% level after BOE (Bank of England) announced that it would purchase unlimited long-term government bonds in order to curb long-term interest rates. US stocks rebounded after the S&P 500 index-based undervalued forecasted PER fell to 15.8x in the first half of this week has been reviewed. For the time being, whether long-term interest rates can remain stable while factoring in the peaking out of inflation and the economic slowdown is vital for stocks to regain their stability.

2. FOMC outlook suggested weakening fundamentals

At the FOMC held last week, FRB also released its “Economic and Interest Rate Outlook” which is updated every three months (Chart 2). As the known saying, “Don’t fight the FED,” it shows the fundamentals that the market should factor in. Regardless the FOMC forecast (actually the forecasted median by FOMC members) whether is correct or not, the bond and stock markets are likely being forced to form interest rates and stock prices in line with the financial authorities’ forecasts. To summarize the FOMC’s latest outlook, Chairman Powell’s press conference and other FRB officials’ statements, it means, “In order to curb persistently high inflation, We will continue to raise the policy interest rate even if we tolerate an adequate economic downturn (revising the GDP growth rate downward the unemployment rate upward).” It seems the stock market is factoring in the economic downturn, which could be called a “side effect” of monetary tightening.

There is also a view that the FRB’s economic outlook is naive (optimistic). Anticipating the impact of the cumulative effects of policy interest rates been raised at an unprecedented pace and QT (quantitative tightening), the probability that US will fall into a recession within a year has reached 50% (average of economist forecasts/Bloomberg’s survey).　In fact, short-term interest rates (2-year bond yields) and long-term interest rates in the bond market have continued to reverse (short-term interest rates > long-term interest rates = inverted yields). There is also a growing view that the US economy will inevitably enter into a recession in 2023. Jamie Dimon, CEO of JPMorgan Chase, made an alarming statement in the public hearing in the US House of Representatives on September 21, “Uncertainty over global energy and food supplies due to the Ukraine crisis could further weaken the economy.” Considering this situation, it is expected that long-term interest rates, which are sensitive to future economic trends, will stabilize or decline (even if policy interest rate and short-term interest rate rise). It is hoped that it will support the stock market centered on growth stocks.

3. US stock valuations confirmed by earnings yield spreads

What will be the appropriate investment strategy while the US stocks are in correction mode? Chart 3 reflects the relative levels of stock prices over the past 30 years in “earnings yield spread” (long-term interest rates - earnings yield) for valuation analysis. “Stock earnings yield” is the reciprocal of the forecasted PER (Price Earnings Ratio), which indicates the forecasted EPS yield to the stock price (12 months forward looking earnings per share ÷ S&P 500 index). It calculates the difference between long-term interest rate and stock earnings yield (= earnings yield spread) and analyzes whether “the stock is expensive compared to bond” or whether “the stock is cheap compared to bond”. In this model, the higher the earnings yield spread, “the more expensive the stock is compared to the bond”, and the lower the “cheaper” the stock. For example, looking back just before the burst of the IT bubble in early 2000, the S&P 500’s forecasted P/E increased to about 25.5x and long-term interest rates had risen to 6.7%. The earning yield spread at that time increased up to +2.8%, indicating that “stocks were excessively expensive compared to bonds”. On the other hand, the current forecasted PER is about 16.1x (stock yield is about 6.2%) and the long-term interest rate is about 3.7% (September 28). Therefore, the profit yield spread is -2.5%. Although it is close to the arithmetic average of earnings yield spreads over the past 30 years (-2.2%), it is hard to say that stocks are overpriced relative to bonds. Moving  forward, as inflationary pressure gradually eases and uncertainty over the policy interest rates recedes, long-term interest rate will stabilize or decline. I believe that the stock market may bottom out and recover through improved valuations. At this point in time, I believe that an investment strategy with a long-term perspective will be likely beneficial.