04.06.2022: The 10-year Treasury yield broke through 2.6 per cent this morning on hawkish Fed comments, leaving the benchmark Treasury yield more than one percentage point higher than when 2022 began. The implications for equities are fraught. “Fair value” in the equity market is a function of two factors: earnings and interest rates. All other things being equal, higher earnings tend to boost equity prices while higher interest rates tend to depress them. Since the beginning of the year, earnings growth estimates have been raised to nearly 12 per cent. Interest rates, however, are also meaningfully higher. This suggests stock prices should be lower year to date, and they are. The S&P 500 Index is off nearly five per cent so far this year, while the NASDAQ is more than nine per cent cheaper. International and emerging equities are off similarly. But have markets adjusted enough?

Graph 1, Market Update, 04.06.22

The math says markets are not down enough to compensate for today’s higher interest rates. The table below was a snapshot of various interest rates and earnings growth rates taken at yearend 2021. At that time, S&P 500 earnings were expected to grow by eight per cent this year and the 10-year yield was 1.51 per cent. Since then, the 10-year note has pushed through 2.5 per cent and earnings growth is estimated at 11.7 per cent. By our reckoning, the S&P 500 should be off 16 per cent, not five per cent.

Graph 2, Market Update, 04.06.22