01.11.2023 Blame inflation readings not seen in over 40 years: 2022 saw interest rates spike between two and four percentage points. The yield surge punished bonds and stocks, sending them down 13 per cent and 18 per cent for the year, respectively. But as difficult 2022 was from an investment perspective, 2023 will be a year in which other parts of the economy – like housing, production, labor markets and earnings – could fully respond to the tighter financial conditions set in motion last March.
Due to the nature of valuation, equity markets respond instantaneously to higher interest rates through multiple compression. Earnings yield, the reciprocal of the price/earnings ratio (P/E), ebbs and flows with the 10-year, BBB bond yield. The 18 per cent decline the market witnessed last year was almost entirely due to a shrinking market multiple, with the S&P P/E sliding to 17x from 23x at the beginning of the year. It is interesting to note that earnings growth expectations rose last year.
The Federal Reserve’s overnight interest rate, the primary mechanism the central bank uses to guide the economy, spiked at a pace not seen since the early 1980s. Yet, because of the lag between the higher cost of capital and its effect on economic activity, we have yet to see the full impact of Powell & Company’s policy. Despite the higher yields, the US unemployment rate fell to 3.5 per cent in 2022 and wages are still rising.
Historically, the lagged impact of higher overnight rates on various parts of the economy is often not felt for months, sometime longer than a year. Housing, due to the direct link between overnight rates and mortgage rates, is probably one of the first economic sectors to feel the pain of higher yields. Housing starts skidded nearly 30 per cent last year. The jobs market is one of the last.
We expect economic indicators to begin to fall in line with interest rate reality in 2023. However, history suggests the full impact won’t be felt for many months, considering peak tightening, according to the futures market, isn’t expected until sometime in Q2. S&P profits could bottom in 2024 and unemployment may not peak until 2025, if this tightening cycle follows historical norms.