The article below is from our BRIEFINGS newsletter of 14 October 2021
Amid rising worries over inflation and rates, investors are anxiously assessing the impact for stocks. We sat down with Goldman Sachs Research’s Ben Snider who shared his thoughts on what he sees as the biggest concerns for equity investors, the interplay between rates and equities, and what to expect for the upcoming earnings season.
Ben, how significant has the low-rate environment been to your constructive view on equities, and how does that view change, if at all, as we see real rates rise?
Ben Snider: Declining rates have certainly given a major boost to equities, which you can see clearly in valuations. If you look at absolute metrics, such as price-to-earnings, price-to-book and EV-to-EBITDA, valuations seem extremely high, ranking between the 95th and 99th historical percentiles. But when you adjust for today’s low interest rates, equities actually look more attractively valued than historical averages. Now as rates begin to rise, valuations potentially come under pressure, and that’s heightened by the fact that in recent years markets and portfolios have become concentrated in secular growth stocks that are particularly rate-sensitive. So it’s not surprising that the most common question we get is: “How high would rates need to rise before they hurt equity investors?” In our view, rates would have to rise dramatically to threaten equity valuations. As an example, if you were to keep the current S&P 500 P/E multiple constant at around 20x, we’d have to see the nominal yield on the 10-year Treasury jump to roughly 2.3% for equity valuations to rank above their historical averages on a relative basis.
Assuming we don’t see such dramatic rate increases, what else could shift the needle on equities’ attractiveness?
Ben Snider: Besides the level of rates, the volatility of yields is also important dynamic. Historically, when rates rise by two or more standard deviations in a month, equities react poorly. We saw this play out in February and March, as well as in recent weeks. So going forward, we would expect rates to rise but would be more focused on the volatility than the level of the rate increase. It’s also important to consider why rates are rising. If it’s because growth expectations are improving, equities generally do pretty well in that type of environment. But what’s troubling investors today is the expectation of Fed tightening which, in turn, is lifting real rates. So even if rates are rising, that doesn’t mean that equities will decline in absolute terms. In fact, we expect equities—driven by earnings growth—will continue to appreciate alongside modestly higher yields. Consider this: Corporate earnings have accounted for all of the year-to-date S&P 500 returns.
So as we kick off another U.S. earnings season, what are you expecting?
Ben Snider: The earnings reports themselves should be pretty strong, with bottom-up consensus numbers forecasting year-over-year earnings growth of 27%. It’s pretty amazing to be discussing concerns around the earnings outlook when you’re expecting that kind of growth, but the reality is that it’s a sharp deceleration from the 88% earnings growth reported in the second quarter. Analysts have been very conservative with their estimates given the high levels of macro uncertainty and cautious management guidance, and bottom-up consensus is actually forecasting 50 basis points of profit margin contraction this quarter compared to the last, which we think highlights a key focus for this earnings season: Input cost pressures. Investors and corporate management teams we’ve spoken with have been very focused on factors related to input costs, from labor supply and wages to energy input costs to supply chain problems. The real question this season is how companies are dealing with these pressures. Because analysts have set a low bar, in my view, we do expect a good amount of “beats”, although we expect the stock price reactions to be muted with investors more focused on management guidance.