When markets are priced for perfection, a slight shift in sentiment causes much damage. This is what we saw last week, after U.S. jobs report showed wage growth accelerated at its quickest pace since mid-2009. It seems the Fed will be faced with a new challenge after Janet Yellen’s departure, and investors are adjusting fast to the new reality.
Global above-trend synchronized growth, enthusiasm over the Trump administration’s fiscal policies, and strong earnings growth have been the key ingredients that fueled the equities rally throughout 2017. Moreover, while inflation remained absent, investors had more reasons to take risks given the low borrowing costs companies were enjoying. Now with inflation indicators heading north, the Federal Reserve is expected to move more aggressively than previously thought.
The era of cheap money is ending, and for markets who got addicted to it, it’s undoubtedly bad news. Today, 10-year U.S. Treasury yields are trading at a four-year high of 2.87%, an 18% increase from where they started the year. This suggests, Jay Powell, the new Fed Chair will be facing the opposite challenge of Ms. Yellen, during his tenure. If inflation runs faster than previously estimated, the Fed will need to speed up the pace of hiking rates from three to possibly four or five in 2018. The consequences might be severe on equity markets which enjoyed the second-longest bull run ever.
Equity bulls may argue that despite the spike in bond yields, they are still considered much lower than where they stood back in 2007 when 10-year treasury yields peaked at 5.33%. This is entirely true, but also in 2007, the S&P Cyclically Adjusted PE Ratio peaked at 27 compared to 33 currently. Although the earning season looks magnificent, forward PE ratio stands above 18 times, which is significantly higher than both the five and ten-year averages. The markets overstretched valuations may no longer be justified when interest rates surprise to the upside.
The only way to justify high valuations going forward is to see economic and earnings growth resuming their uptrend, despite facing higher borrowing costs. Will President Trump’s fiscal policies make the magic? That is what should equity bulls bet on.
It’s important to see how investors react when Wall Street opens today, as it may determine whether the selloff will attract buyers, or it suggests a start of a more significant correction; however, future indices aren’t showing signs of optimism as of now.
The dollar is also likely to attract some attention after being dumped throughout 2017, particularly against emerging market currencies, if the selloff in equities resumes.