The impact of inflation and interest rates on companies’ price to earnings ratios

Roger Montgomery

Montgomery Investment Management

Currently-surging US inflation has triggered a dramatic move in interest rate expectations, which in turn have inspired equity investors to reassess the risk they are willing to adopt. In the space of seven months, US short-term interest rate expectations have moved materially.

Back in July last year, the US Federal Funds rate was expected to be 0.3% by the end of calendar 2022. Today, the rate at that time is expected to be 1.25%. And the old 0.3% target is now expected to be exceeded in a matter of weeks.

The shift in sentiment to higher rates, and sooner, has been dramatic. And the repercussions for equity investors have been impossible to ignore. 

The simple fact is, for the last four decades, whenever inflation or interest rates have risen, the multiple of earnings investors have been willing to pay for a share in a company has declined. In every one of the seven phases US 2-Year Treasury yields rose between 1980 and today, the US S&P500 12-month forward PE Ratio declined.

PEs decline when interest rates rise

Some investors will also be interested to note correlation analysis, on data back to the 1980s, reveals the decline in the earnings multiple is greatest when interest rates move up from lower starting levels.

Meanwhile, more recent history reveals a contracting US Federal Reserve balance sheet (tapering or shrinking) tends to produce lower returns for S&P500 equity investors. Importantly, except for the COVID-19 sell-off in 2020, every period of negative year-on-year returns for the S&P500, since 2010, coincided with tapering balance sheet growth or a shrinking balance sheet. But keep in mind, any acceleration of Quantitative Tapering could also lead to lower interest rate hikes than some are anticipating.

Perhaps unsurprisingly, January’s changing interest rate expectations – Goldman Sachs now anticipates seven Fed rate increases in 2022 – has resulted in some very substantial multiple deratings. Investors are simply unwilling to pay as much for a dollar of earnings as they were just ten weeks ago.

Share prices are a multiple of the underlying company’s earnings. When price-earnings multiples are contracting, the only offset for share prices is rising earnings. To counteract the multiple declines, the underlying company must grow profits. For a company that manages to grow its earnings meaningfully, the PE contraction will prove a depressing but transitory influence on the share price. Even if the PE doesn’t expand again, the growth in earnings will drive the share price higher. Of course, this takes time for a company to achieve. That delay to prices going up – in tandem with earnings – provides investors with an opportunity.

Before embarking on that plan however it is worth exploring the market’s present obsession concerning interest rates and inflation.

Does the current situation look familiar?

The current combination of expected rate hikes and US Federal Reserve balance sheet contraction looks remarkably similar to 2018. Three years earlier, in 2015, the US experienced an oil meltdown and a nominal recession. Then, in 2016/17 the US economy commenced its recovery. The US was growing at 3.8 per cent, and Trump’s tax cuts provided an additional boost. The economy was thought strong enough to support four rate hikes.

Between September and December 2018 however, the S&P500 had fallen to produce a minus seven per cent nominal return for the calendar year. The Fed went too hard and backed off. The following year, in 2019, the S&P500 generated a 30 per cent return.

One needs to remember the Fed is open to changing course. While the commentary out of the Fed today is hawkish, a sufficiently negative reaction from the stock market would be enough to cause the Fed to pause. Fed pragmatism isn’t dead. Indeed, equities, as a percentage of US household assets, are at a record high of nearly 30 per cent. It is even higher than real estate, which represents about 25 per cent of assets. A sufficient fall in equity markets would negatively impact GDP. The heightened economic sensitivity to markets could prompt the Fed to temper some of its enthusiasm for rate hikes.

That is certainly the case elsewhere in the world. European Central Bank President Lagarde has warned against moving quickly on rates as has ECB chief economist Philip Lane. In Australia, the RBA’s Governor Philip Lowe reiterated patience, with the Bank of Japan is reported to have announced a plan to buy unlimited Japanese Government Bonds.

At the same time, the Fed is most hawkish about interest rates, leading indicators are also suggesting inflation may have peaked. At the margin, the overall strain on the supply chain appears to be easing. Supplier delivery times are shortening again and the backlog of orders is falling. The ISM Manufacturing Prices Paid Index has already begun declining and prices for container freight, dynamic random-access memory, natural gas in Germany, and thermal coal in China are also declining.

What will happen as borders reopen?

And as international borders open, two things happen; first pressure on wages declines because skilled and unskilled immigration returns. I note US non-farm unit labour costs recently turned lower. Second, a mix-shift in spending away from goods and towards services, such as travel and entertainment, reduces the demand for goods and with it the pressure on their prices.

There is a real possibility that just as the market is at maximum fear about inflation and rising rates, inflation is peaking.

Meanwhile, stocks have seen some tremendous falls. While the S&P500 has declined 3%, more than 42% of its constituent companies have fallen more than 10% from their 52-week highs. The NASDAQ Composite index has fallen 7% from its 52-week high but the proportion of companies that have fallen by 10% or more is approaching 80%.

Despite the share price falls, and following the near 50% earnings growth rates recorded for S&P500 and ASX200 companies in 2021, earnings growth for 2022 is expected to hit 8% and 13% for S&P500 and ASX200 companies respectively.

On top of continued earnings growth, the real yield (the difference between bond rates and inflation) remains negative, which is a positive for investing in equities, and the earnings yield for the S&P500 is well above the yields offered on bonds, rendering them more attractive.

Periods of equity market weakness are defined by the abandonment of long-term investment plans and their replacement with short-term fears about where prices will land.

This sell-off is occurring as the US Fed is tightening into the second most expensive market in history. I believe the ensuing volatility will provide another opportunity for experienced and patient investors.

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Roger Montgomery
Chief Investment Officer
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger brings more than two decades of investment, financial market experience and knowledge. Roger also authored the best-selling investment book, Value.able.

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