On Wednesday, in the ongoing attempt to fight inflation, the Federal Reserve raised interest rates by 50bps to a targeted range of 0.75-1.00%, marking the largest rate increase since 2000. In addition to raising interest rates, the Fed also announced that starting on June 1st, the central bank would begin unwinding its balance sheet at a rate of $47.5 billion/month ($30 billion in Treasuries & $17.5 billion in mortgage-backed securities) for the next three months & by $90 billion/month ($60 billion in Treasuries & $30 billion in mortgage-backed securities) thereafter. Prior to the announcement, equity markets were trading in a fairly narrow range as investors positioned themselves for the Fed’s decision on interest rates with some Wall Street professionals anticipating a 50bps hike while others were forecasting a 75bps hike. Immediately following the announcement, equity markets sold off as the raising of interest rates is typically seen of as bearish for equities. Once Fed Chairman, Jay Powell, began his press conference, equity markets rebounded to have their best performance of the year as Powell made a particular comment that markets took as a very dovish sign. With Powell stating that a 75bps interest rate hike was not something that the FOMC was considering, equity markets were off to the races in the final hours of trading.
Market Update – Fed Raises Rates
However, the optimism quickly soured as equity markets experienced their worst day since 2020 the following day as investors & the markets digested Powell’s comments & their implications moving forward. Many on Wall Street viewed his comments, particularly the comment that took a 75bps interest rate hike off the table, negatively. It is apparent that the Fed must raise interest rates in order to combat inflation. It is also becoming more apparent that the Fed is “behind the curve” when it comes to raising interest rates as inflation continues to move higher every month. With that in mind, Wall Street professionals think that Powell made a mistake by taking a 75bps interest rate hike off the table with the belief that the Fed needs to be more aggressive when it comes to trying to contain the record high inflation that we have been seeing for almost a year now. That being said, the graphic below appears to indicate that market participants don’t fully believe what Powell had to say as markets are now pricing in an 82.9% probability of a 75bps interest rate hike at next month’s FOMC meeting, which would bring the new targeted range for the Fed Funds rate to 1.50-1.75%.
So what does this all mean moving forward? As of right now, markets are pricing in an additional 200-225bps worth of interest rate hikes by the end of the year, which would bring the year-end targeted range for the Fed Funds rate to 2.75-3.00% (200bps) or 3.00-3.25% (225bps) – a level that we have not seen since the Fed started lowering interest rates in 2008. For reference, prior to the Fed cutting interest rates in 2020, the upper bound for the Fed Funds rate was 2.5%. Looking at the graphic below, the last time the Fed Funds rate hit 3%, yields on 10-Year U.S. Treasuries were at 3.88% & the 12-month forward price-to-earnings multiple (“P/E multiple”) was hovering right around 14x.
With interest rates set to keep increasing for the rest of the year & potentially into 2023, earnings multiples will be forced to come down but to what magnitude remains to be seen. Should multiples come back down to the 14x level that we saw the last time the Fed Funds rate was at the 3% range, based off of CFRA’s estimates for FY2022 earnings of $228.17, that would imply a 3,200-level on the S&P 500. However, according to FactSet, the 5- & 10-year historical average 12-month forward P/E multiples are 18.6x & 16.9x, respectively. With S&P 500 earnings expected to come in at $228.17 for the year, an 18.6x multiple would imply 4,240 on the S&P while a 16.9x multiple would imply 3,850 on the S&P by year end. That being said, according to FactSet, 80% of S&P 500 companies who have reported earnings so far have reported an earnings beat. We would expect this trend to remain for the rest of the year as companies continue to figure out ways to either absorb higher input costs or pass those costs on to the consumer. While we do not believe we will see another 22% drawdown from the current levels, we do believe that the rest of the year will be quite volatile as the Fed continues to raise interest rates & equity markets digest the macroeconomic data. As we navigate the volatility & uncertainty that will undoubtedly persist in the near term, we will remain diligent when it comes to positioning our portfolios.