As investors have become comfortable with the consecutive interest rate increases from central banks, the TSX, S&P 500, and NASDAQ experienced massive rallies over the past few weeks. The TSX inflated over 10% since its year-to-date bottom, followed by the S&P 500’s nearly 18% rally, while the NASDAQ climbed over 23%.
However, some investors forget that high-interest rates are not going away anytime soon. Here’s why:
Inflation is Still Overheated
Firstly, it’s important to recognize that inflation around the world is still overheated. Canada and the United States, for instance, have inflation of 7.6% and 8.5% as of July Consumer Price Index (CPI) data. Both countries have their policy interest rate set at 2.5%, although it likely won’t be long until it moves higher.
Throughout history, inflation had to be fought with an equally as high or higher policy interest rate. Otherwise, inflation would still have the fuel necessary to continue accelerating during the short-to-medium term.
In the 1980s when inflation was nearly 15% in the United States, there were swift actions taken by the central bank to decelerate the surging prices. Back then, inflation was caused by central bank policies that enabled growth in the money supply. The parallels between now and then are striking. Except, our inflation was largely created by CERB and stimulus packages being sent to individuals in North America who were now unemployed—thereby increasing the money supply.
Macroeconomically, the fundamental conditions that led to the exponential increase of inflation in the 1980s were also lurking during 2020. Economists just wouldn’t see the effects until two years later.
Why the Incentive to Own Stocks Could Deteriorate
At the start of the year, the first companies to get punished were small and mid-cap stocks. The incentive to own low-yield dividend-focused companies is also gone. This is because the 10-year note currently yields a higher return than the S&P 500’s average dividend yield of 1.5%.
However, Canada in particular has a variety of equities paying over 3% to shareholders. If the 10-year note were to move higher—which can sometimes rise with interest rates—there would be a sudden realization across the entire market that the risk of owning equities would be too high in comparison to more risk-averse assets which pay similar rewards.
As a result, it seems investors are brutally underprepared for what could occur within the next few months as central banks continue to tighten their monetary policies to de-accelerate inflation.
Additionally, valuations are still a concern in the public markets, primarily within the S&P 500. The cyclically adjusted P/E ratio, also known as the Shiller P/E, is currently 31.1. For comparison, the dot-com bubble reached a Shiller P/E of 44.1 and crashed down to nearly 23. According to 150 years’ worth of stock market valuation data, the median is 15.8. With that being said, multiple compression can happen in a handful of ways.
If quarterly earnings across the S&P 500 begin to drop, or the price of equities within the index drop, the valuation multiple would compress. Conversely, if earnings began to soar while equity prices remained stagnant, that could also shrink the ratio. Though, the latter is rather unlikely given macroeconomic headwinds.
Overall, there is a strong possibility that investors haven’t yet recognized that high-interest rates, alongside further uncertainties, are likely to persist over the next few years.
