Since September 14, the nominal yield on 10-year U.S. Treasury bonds has increased by 26 basis points (1.28% to 1.55%), and the real yield on 10-year U.S. Treasury bonds has increased by 20 basis points (-1.05% to -0.85%).

However, rate movements so far are less dramatic than in early 2021, but the economic environment is less favorable for stocks at present. In general, stocks have struggled when higher real rates were driven by perceived changes in Fed policy (e.g., "taper tantrum" in 2013, "long way from neutral" in 2018) and performed better during periods of improving growth (e.g., after the 2016 election, passage of tax reform in late 2017). The real yield on 10-year U.S. Treasuries rose 50 basis points between late February and mid-March, a move of about 3 standard deviations. However, that move largely reflected the continued improvement in the economic growth outlook following the vaccine announcements in early November. Today, economic growth is slowing, and the Fed is expected to announce the start of tapering at its November meeting.

So the question that follows is… Is an aggressive Fed a problem for equity markets?One transmission channel through which a more aggressive Fed could hurt equities is via an increase in real rates, as higher real yields reduce the relative valuation advantage of equities versus bonds. However, we continue to find it difficult to characterize stocks as expensive when real yields remain so negative, with the 10-year real UST at -88 bp. This level of real yields implies an equity risk premium of around 5.3% currently for the S&P 500. In the previous correction of 2015 and 2018, the equity risk premium bottomed at 4.5%. So, mechanically, we would need to see the 10-year real yield increase by 80 basis points from here for equity risk premiums to decline to 4.5%.

We continue to believe that the speed and composition of rate movements will be more important for equities in the short term than the level of rates itself.Equities remain attractively valued relative to the level of interest rates. Using a P/E multiple of 20x and a 10-year UST yield of 1.5%, the earnings yield gap between equities (4.9%) and bonds is equal to 345 bp, ranking only in the 39th percentile compared to history. With no change in P/E, the 10-year UST yield would need to rise above 2.3% for relative stock valuations to move above their long-term average.

With these variables, we are in a position to project the potential of equities going forward. Barring any major negative surprises, we believe that the fairest value levels for the S&P 500 would be between 11% and 13% from current levels, with downside risk limited to 6% (for which we assign a low probability of occurrence), meaning that recent adjustments would still qualify as a "Buy the Dips" opportunity. 

Our baseline scenario assumes that base rates will end the year at around current levels (with some upside risk), although by 2022 we will need to start considering higher interest rates in a context of greater inflationary pressures, but also because we expect global growth to pick up again.

For now, we prefer to be conservative with our earnings estimates for 2022, with an expected EPS of US$220 (+10%) for the S&P 500 (around the market consensus), although we preliminarily believe that there is upside risk considering that growth expectations for 2022, both globally and for the US itself, would continue to be above potential and, barring rampant inflation, earnings growth could well exceed expectations.