As often occurs in market corrections, January’s selloff inspired much speculation, but there remains just one incontrovertible fact: after delivering 27% returns in 2021, the S&P 500 fell 5% in January, having been down more than 11% at one point.
Market participants offer various theories about what triggered the decline, including stretched technicals, elevated valuations, a moderation in earnings, and, most commonly, Federal Reserve (Fed) policy.
This correction had a different tone to it than the “blink and you miss ‘em” dips we saw in 2021. But in our view, it remains just that – a correction.
Nevertheless, the economic and policy landscape has clearly shifted, so it is worthwhile to calibrate the importance (or otherwise) of the factors assumed to be behind the recent market moves.
Fading economic momentum and policy accommodation
Where are we today? Simply put, the momentum and policy accommodation of the last year-and-a-half are fading. We continue to believe that underlying economic growth will be strong this year, and earnings offer good upside to expectations.
But as market pricing moves to calibrate the new policy and growth environment, investors are no longer rushing to buy dips. Despite stabilising in the past few sessions, we think this period of choppiness could still last a little while longer – possibly until the Fed’s rate hiking cycle is underway – before economic and earnings growth regain the upper hand.
The correction can trace its origin back to the release of the Fed’s December Federal Open Market Committee (FOMC) minutes on 6th January, in which the Fed clearly underlined its hawkish intentions.
As investors further reassessed the Fed’s reaction function from neutral/dovish to outright hawkish, the real rate repriced accordingly.
44Now, with four-and-a-half 25bps hikes in the fed funds rate priced in for 2022 – and policymakers hinting very strongly that the Fed’s balance sheet will start shrinking by mid-year – 10-year US real rates have leapt from -110bps to -60bps. In turn, equity multiples have contracted sharply, with the derating assumed in some quarters to be tied solely to the rise in real rates.
Real yields and equity multiples
While over the most recent cycle there was a negative statistical relationship between real rates and equity valuations – multiples rising with falling real rates, and vice versa – we note some important subtleties. This correlation is rather weak, unstable through time and, most crucially, says little about causation.
Admittedly, the real yield appears to correlate most strongly to equity multiples when the yield move is greater than one standard deviation.
The 50bps move in January certainly qualifies in this regard. But even so, extrapolating to a high conviction bearish view on equities from this lone observation lacks robust empirical support.
This is reinforced by the lack of historical precedent for today’s market context, where multiples sit near multi-decade highs, and U.S. real yields near multi-decade lows.
Overall
The sharp change in the real yield is indicative of a shift in the underlying policy framework, the effects of which must also be calibrated across other asset markets. Today, a moderation of economic momentum and the repricing of the Fed’s hiking cycle have raised uncertainty across asset markets.
As we’ve noted, real yields have already moved meaningfully higher. But unless real yields rise so far that tight financial conditions choke off growth, equity prices, and in turn multiples, should find some support.
In our view, the Fed is willing to be hawkish. It wants to bring rates back to neutral, but not at any cost, and certainly not at the price of an economic contraction. As a result, real interest rates are unlikely to move far into positive territory in this cycle, and indeed could remain negative.
Multiples are contracting as the stock market adjusts to the new environment, but we do not anticipate persistent and dramatic multiple contraction from here. Indeed, with the US forward price-to-earnings (P/E) multiple now at around 19x, even US valuations have fallen 20% from their peak.
The decline in P/E multiples from peak has been even larger in other regions. That move is consistent with past economic transitions from early-to mid-cycle.
We may see further moderation in equity multiples in the weeks to come, especially if earnings forecasts drift up a little to reflect the aggregate growth reported in the fourth quarter earnings season.
Equity markets traditionally struggle in the run-up to the first rate hike in a cycle, so there may yet be some bumps in the road. But with economic momentum strong and earnings likely to rise over 2022 and 2023, we expect stock markets to weather the hiking cycle well once its underway.
In sum, we see nothing more alarming than a correction within a longer-run bull market trend. If current uncertainty begins resolving itself in such a way that suggests the current expansion has room to run and that extreme Fed tightening may not be necessary, markets will likely offer an attractive entry point.
John Bilton is head of global multi asset strategy at J.P. Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.