The question becomes, how can shifting economic expectations impact financial markets? On 12/31/20, we observed: A healthy recovery with growth and a modest uptick in inflation would be reflationary. A rapid one, inflationary. The interaction amongst profits, valuation, and interest rates was the primary driver of the 2021 stock market. This is a concept we introduced on 12/31/20.
While PE ratios are above average, historically low interest rates make such valuations reasonable, as a PE ratio is simple shorthand for discounting future earnings to the present. The following chart compares the forward earnings yield (the inverse of the forward PE ratio) and the 10yr Treasury. The difference, or premium, is shown as well. On 12/31/20, the forward EPS yield (4.4%) was below the 2000 peak, but thanks to the 0.92% 10yr, the premium of 3.5% was in line with the 20yr range. Moving forward to 9/30/21, the EPS yield is higher, at 4.9%, even though the stock market has risen. This reflects the improved economic outlook. And this means that, despite the higher 10yr at 1.53%, and the 16% ytd increase in the S&P 500, the earnings premium has been steady. This is the first way the equity markets have held up, despite rising rates.
After this valuation analysis of the overall market, on 12/31/20, we noted: This pressure would not be even across the markets. Low rates have favored Growth over Value, as high multiples are based on future earnings. Higher rates favor current earnings and would be an advantage for Value. In addition, if it’s a “good” reflation cycle paired with an improving economy, that could further help Value style companies that are typically more economically sensitive.
The chart demonstrates how the relationship between rising rates and the Growth/Value relationship was one of the most prominent drivers of 2021 thus far.
Looking at cumulative year-to-date, they are about even, Value is +15% while Growth is +16%, but the performance has been highly conditional to the 10yr. On days the 10yr has risen, Value outperformed Growth by 25%. On days the 10yr declined, Growth outperformed Value by a comparable 28%. The see-saw between Growth and Value has allowed the market to appear steady, despite rate moves being felt below the surface.
As an indicator of how fast it can shift, after the Fed’s meeting on 9/23, through the end of the quarter, the 10yr rose 20 bps from 1.33% to 1.53%. In this period, Value outperformed Growth by 2.7%, cutting, what up until then appeared to be a strong Growth over Value quarter, by over half, to just 2% relative performance. This could be a sign of the reflation trade returning. With concerns over the recovery losing steam and/or inflation pressures picking up, the market’s focus remains if this is Reflation or Inflation. Reflation would be favorable for equities, while Inflation would be a headwind. Figuring this out will occupy the markets in Q4’21.
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