The high premium that stocks continue to offer relative to real interest rates continues to justify their overweighting relative to fixed income.

Last week, we argued that by balancing the negative aspects (tighter policies and high valuations) with the positive aspects (low risk of recession), investors are advised to maintain a more or less neutral risk exposure.( https://www.fynsa.cl/newsletter/politica-monetaria-2/)

This week, we will take a closer look at what this means in practice in terms of the potential of US equities.

It is true that the market has so far digested relatively well the "tougher tone" set by the Fed, on the understanding that it will be able to achieve a "soft landing for the economy" and not make a policy mistake that ends in a recession.

We agree that, for now, the risks of recession are limited and that the US economy is in good shape to absorb a less accommodative monetary policy. Therefore, the expected growth in corporate earnings of around +8% for S&P 500 companies would not be "at risk."

However, as inflation risks remain high, at least through the first half of 2022, the market has been leaning toward a more aggressive monetary normalization process than that established by the Fed just a week ago. In other words, the guidance for federal funds rates over the next two years (2.8%) could end up being brought forward almost entirely to this year.

Proof of this is that expectations of further rate hikes at the May and June FOMC meetings have begun to incorporate a growing probability of 50 bp per meeting (probability of +68% and +71% respectively), reinforced by statements made by Powell and other Fed members in recent days, who have made it clear that price stability is the "priority" today. The attached table also shows that the probability of the rate ending this year at 2.8% is already 32%, a low but growing probability.

Of course, this is putting additional pressure on market rates, with the 2-year Treasury trading above 2.1% and 10-year rates at almost 2.4%, which is practically the levels we expected for 2022, but now we believe could be closer to 2.7%. This implies a further flattening of the yield curve and a potential inversion of the curve later in the year.

With this in mind, we see very limited potential for equity multiples to expand, and the upside potential is entirely dependent on expected corporate earnings growth.

For now, the market is holding steady at real rates that remain very expansionary (-70 bp at 10 years), levels that we consider very low compared to other monetary normalization processes. Although it is difficult to subscribe to positive real rates, given the "greater tolerance" for inflation than in past cycles, we believe that real rates could well approach more neutral levels going forward.

All in all, we are adjusting our projections for the S&P 500 to levels of 4,600 points, consistent with an expected EPS of US$225 per share, a forward P/E multiple of around 20x, and real 10-year rates of -0.3%. This implies some compression of the ERP (equity risk premium) from the current 580 bp to levels closer to 530 bp, which are basically the levels prior to the geopolitical crisis in Ukraine.

The high premium that stocks continue to offer relative to real interest rates continues to justify their overweighting relative to fixed income.

As this is a recurring question, we are incorporating awareness of a potential recession scenario, taking as a baseline the average decline in EPS around recessions (-13%), which would bring the S&P 500 to levels of 3,600, matching the median adjustment for recessions (-24%).

If geopolitical and inflationary pressures ease later in the year, our bullish case considers levels closer to 5,000.

Humberto Mora

Strategy and Investments