US interest rates surge, equities fall

Chief Economist's View

The yield on US 10-year sovereign bonds surged by 13 basis points (bps) this week, reaching a seven-year high. The recent jump in US interest rates, which has seen the US 10-year bond yield increase by around 40bps since late August, has stemmed the rise in the US equity market following a stellar run since March. Driving US interest rates higher this week were strong US service sector and employment data, which reinforced market expectations that the US economy would continue the blistering pace set in the first half of 2018.

And just how fast has the US economy been growing? Over the first half of 2018, US real GDP (the broadest measure of economic activity) has grown at an annualised pace of around 3%, more than a third faster than trend, and economic forecasters are expecting this pace to continue over the second half of the year.

Above-trend growth and tightening labour market conditions are wringing dry any excess capacity from the US economy, which is leading to gradually rising growth in wages and the level of core inflation. In response, the US Federal Reserve (Fed) is holding fast to its schedule of fed funds rate hikes, with the bond market playing catch up. So how will the equity market respond to rising interest rates?

Before we get to the question, let’s quickly look at the recent history of interest rates and the stock market. The first thing to note is that interest rates have been rising steadily in the US since their historical low points in July 2016. Since mid-2016, the yield on US 10-year sovereign bonds has risen by 1.84 percentage points (ppts); from 1.36% in July 2016 to 3.20% at time of writing. Over the same period, US equity prices (as measured by the S&P 500) has risen by a stonking 38%.

Of course, the market’s perception on US economic growth has changed substantially since 2016. Back then, economists were forecasting (barely) trend growth of 2.1% and 2.0% in US real GDP over 2018 and 2019, respectively. Now, economists are expecting 2.9% growth in 2018, followed by another above-trend year of growth of 2.6% in 2019. The increasingly buoyant outlook for the US economy has been reflected in analysts’ company earnings forecasts.

In 2016, analysts were expecting earnings of S&P 500 companies to be growing by 12% in 2018 and by 2017 they were expecting 7% growth in 2019. Now, analysts are anticipating earnings to grow by around 20% over 2018, to be followed by another bumper year of earnings growth of 10% in 2019. These upgrades to the earnings outlook have sustained equity prices over the last two years, even in the face of higher interest rates. But have equity prices now skipped ahead of fundamentals?

According to standard valuation metrics, such as price/earnings (PE) multiples, one could argue that the US stock market is mildly overvalued at current prices. Based on IBES one-year forward earnings estimates, the S&P 500 is currently overvalued by around 10%. So, what can we expect in US bond and equity markets over the coming twelve months? In our view, the market is still underestimating the pace of increase in interest rates.

The Fed has signalled a further 25bp rise in the fed funds rate this year, followed by three more rate hikes in 2019, before peaking at around 3.4% in 2020. While the market is anticipating another Fed rate hike in December, it is pricing only two more hikes over 2019, before topping out at around 3.0% in 2020. In our view, with growth strongly above trend and wage growth on the rise, the Fed will have to raise interest rates more rapidly than the market is currently expecting if inflation is to remain in check.

As it becomes apparent that the Fed will stick to its program of rate hikes, interest rates along the yield curve will rise more rapidly than current market pricing. Our view is that the US 10-year sovereign bond yield will rise from 3.2% currently to 3.5% by the end of next year. With little upside to the expected growth rate in company earnings, and in the face of higher than expected interest rates, the US equity market should undergo a mild correction over the coming year.

Table 1: Financial market movements, 27 September – 4 October 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,901.6

-0.4%

US

3.19%

13.5 bps

US Dollar Index (DXY)

95.75

0.9%

Nikkei 225

23,975.6

0.8%

Japan

0.16%

3.9 bps

USD-JPY

113.91

0.5%

FTSE 100

7,418.3

-1.7%

UK

1.67%

7.1 bps

GBP-USD

1.302

-0.4%

DAX

12,244.1

-1.5%

Germany

0.53%

0.2 bps

EUR-USD

1.151

-1.1%

S&P/ASX 200

6,176.3

-0.1%

Australia

2.71%

2.0 bps

AUD-USD

0.708

-1.8%

Source: Bloomberg

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