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

(07/10/2022)

1. The pain of rising interest rates spreading the world until the 3rd quarter

Major stock indices such as the S&P 500 index, the NY Dow Jones Industrial Average and the Nasdaq Composite Index have fallen for 3 consecutive quarters. The main reason is that the FRB (Federal Reserve Board) has indicated that it will continue to tighten monetary policy at a rapid pace to curb inflation. Chart 1 compares the year-to-date total returns of the world’s major risk assets (stocks, bonds, REITs, gold) and cash. Central banks of the developed countries also raised interest rates and bond market interest rates (yields) soared. Besides conventional risk assets, cryptocurrencies such as Bitcoin were also forced to undergo severe corrections. The distinguish characteristic is both stocks and bonds, which were anticipated having a risk diversification effect due to their low correlation, declined. In contrast, cash which offers no return but no risk is highly appreciated. However, when the US long-term bond yield (10-year bond yield), which temporarily rose to 4% on September 28 dropped, the S&P 500 index recorded its biggest increase since April 2020 on the first 2 business days of October (3rd and 4th). The main factor seems to be short covering (buyback) for the oversold until last week. Decline in market interest rates lowers the discount rate applied to the “discounted present value calculated from future profit forecasts”, making it easier for stocks prices to rebound. Whether or not the global market will stay away from risk-off (risk aversion) stance in the 4th quarter (October-December) will depend on the stabilization of bond market interest rates.

＊Total return = year-to-date total return including dividends, distributed profits and coupons
(Source) Created by Economic Research Institute of Rakuten Securities, Inc. from Bloomberg (End of 2022 – Oct 5, 2022)

2. Global stocks are undervalued in terms of valuation

The only good news in the global stock market decline is that stock prices are lower than they were before. In particular, the forecasted PER (price-earnings ratio) of US stocks (based on the S&P 500 index), which fell by more than 20% from its high at the beginning of the year, is now at the 16x range. Considering that the average ROE (return on equity) for US stocks is just over 22%, if the warned recession is temporary and mild, it is already a bargain (Chart 2). In particular, compared to 2020~2021 when US stocks were trading at 20x to 24x forward PER, the current forward PER ratio is low. Nevertheless, factors behind the drop in forward PER include rising bond market interest rates reflecting high inflation and growing uncertainty about the economy (corporate earnings). We should note that the stocks will tend to be more volatile for the time being.

It is important that the anxiety over future interest rates to subside as it is a catalyst for stock valuations to be reassessed. Chart 3 shows the trends in the US policy interest rate (the guidance target upper limit of the FF interest rate), the short-term bond interest rate (2-year bond yield) that is sensitive to policy interest rate trends and the long-term bond interest rate since 2019. The FOMC (Federal Open Market Committee) held in September suggested to raise the policy interest rate to 4.4% by the end of 2022 and 4.6% by the end of 2023 in the latest economic and interest rate outlook (median forecast). I suggested pulling it up. However, housing costs (imputed rent), which accounts for about 30% of the CPI (consumer price index), began to slowdown, including the slowdown in growth in the S&P Case-Shiller Home Price Index. This is expected to curb inflation. Since the decline in long-term bond interest rates since last weekend was favorable, I would like to pay attention to the movement of US stocks to rebound. In particular, if the CPI announced on October 13 confirms that inflation has passed, it is expected that both bonds and stocks may bottom out.

3. Can we anticipate a year-end high in US stocks?

US stocks slumped from the 1st to the 3rd quarter. But can we expect a bottoming out or a rebound in the 4th quarter (October-December)? It is just for reference. For example, when looking back on the market performance since 1946 after World War II, the average rate of change in the “midterm election year”, which is this year, was the lowest in the 4-year election cycle. However, “the stock prices rose from October to December” in midterm election years. Chart 4 shows the average changes in the NY Dow for the past 10 years in which the midterm elections were held (beginning of the year=100). In past mid-term election years, the market was often sluggish toward the end of September but tend to rebound from October onwards. We cannot deny the possibility of heightened volatility, which factors in the uncertainty surrounding the midterm elections (November 8) this year as well. However, around that time, inflationary pressures may have eased. After the next meeting of the FOMC (November 1-2), if the market determines, “the need for the FRB to tighten monetary policy has diminished”, the bond interest rates may regain stability. Once the inflation outlook and long-term interest rates stabilize, I believe we can expect a scenario of a “year-end high” for US stocks. Based on these assumptions, the near-term stock price correction is considered to be a good opportunity for “buying on decline” and “bargain hunting”.