“Some twisted logic about valuation multiples”: stock market investors seem complacent when rates rise, warns Morgan Stanley

The stock market has been complacent in the face of rising real yields and expectations of a higher terminal value for the federal funds rate, movements observed in the bond market following higher-than-expected inflation in August, the division warns. asset management of Morgan Stanley.

“We would have expected a stock market reaction by lowering valuation multiples and lowering earnings estimates,” Morgan Stanley Wealth Management Chief Investment Officer Lisa Shalett said in a statement. “None happened.”

US Treasury market yields have continued to rise since the Department of Labor released consumer price index data on September 13 showing inflation was stronger than expected in August. Rates have risen as investors expect the Federal Reserve to announce another large rate hike to combat rising inflation at the end of Wednesday’s policy meeting.

“For most investors, ‘higher the longer’ refers to inflation and, in turn, the terminal level of the federal funds rate during this historic rally,” Shalett said.

“The implication, at least for the US Treasury market, is that real rates across the entire yield curve are likely to rise,” he said. “But in the stock market, ‘higher longer’ apparently refers to a twisted logic about valuation multiples.”

The stock market has been relatively resilient as investors appear to anticipate a “rapid resolution of the fight against inflation” and a return to the pre-COVID 19 paradigm of low growth, low inflation and an accommodating Fed, according to the note.

“While higher real rates due to policy tightening should mean immediately lower valuations and lower end earnings, the forward price-to-earnings (P / E) ratio based on consensus estimates is 17.4,” wrote Shalett. . “This is exactly what it was in May, when the 10-year real rate was negative.”

Real rates affect inflation, which this year has been at the hottest pace in decades.

“The 10-year real yield of the Treasury, at 1%, is approaching a four-year high,” said Shalett. “He considers that in June, when the real rate was at this level, the S&P 500 index was at 3,667, 5.3% lower than today.”

The S&P 500 fell to a year low of 3666.77 on June 16, with some investors expecting that level to be tested again as the Fed maintains its aggressive rate hike pace. “Now is not the time for complacency or wishful thinking,” said Shalett. “We expect a new test until the June low”.

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Most investors expect the central bank to raise the policy rate by three-quarters of a percentage point after this week’s policy meeting, according to CME FedWatch Tool on Monday early afternoon. The federal funds rate is currently in a target range of 2.25% to 2.5%.

“With the forecast for the Federal Terminal Funds rate now approaching 4%, investors are wondering whether the 10-year US Treasury yield will exceed its cycle range and trade higher, or remain pegged and thus risk a ‘inversion of the yield curve “, according to Shalett’s note.

“10-year Federal / Treasury yield curve inversions are rare,” he said. “They generally coincided with significant stock market falls, as happened in 2001, 2006 and 2018.”


“Most investors are betting that the Fed will not ‘over tighten’, but the risks of a hard landing are certainly on the rise,” said Shalett.

The 10-year Treasury bond yield TMUBMUSD10Y,
It rose about two basis points to about 3.47% in early Monday trading afternoon, according to FactSet data, at the last check. This is after the 12.6 basis point increase last week, at its seventh consecutive weekly increase, according to market data from Dow Jones.

Meanwhile, the two-year Treasury makes TMUBMUSD02Y,
it jumped seven basis points to 3.93% early Monday afternoon, after also rising for seven consecutive weeks.

The reversal of two-year and 10-year yields, meaning that the short-term rate has moved above the longer-term rate, has historically been an indicator of a potential recession.

Laws: A punitive short-term debt sell-off is pushing a rate close to the “magic” level that “scares” the markets

US equities were struggling to find direction in early afternoon trading on Monday as investors prepared for the Fed’s two-day policy meeting starting Tuesday.

The Dow Jones Industrial Average DJIA,
+ 0.64%
increased by about 0.1%, while the S&P 500 SPX,
+ 0.69%
and the Nasdaq Composite COMP,
+ 0.76%
they were almost flat, according to FactSet, at the last check. All three major benchmarks fell last week, with the S&P 500 and Nasdaq having their biggest weekly dips since June.

“Instead of lowering valuation multiples and earnings estimates, equity investors appear to believe that a more aggressive Fed will result in an acceleration and hike in final rate cuts, leaving higher P / Es more to long, “he said. “We think this thesis is flawed.”


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