U.S. stocks have clearly perked up so far this year. But now, two key market metrics show a heightened level of risk in domestic equities that we’re watching closely.
The chart below highlights both the terminal federal funds rate—the highest expected level for the fed funds rate in the current tightening cycle (the blue line)—and the valuation of the S&P 500 Index overall (using the forward 12-month price-to-earnings ratio, in pink). Notice how stock valuations fell significantly, for the most part, as the Fed accelerated its interest rate hikes (and as the terminal rate rose) last year to combat runaway inflation. That makes sense: As the cost of capital rises, it puts downward pressure on stock valuations.
But note where we find ourselves today:
- The estimated rate ceiling is at its highest level in years, with expectations that the fed funds rate will go as high as approximately 5.2% as the Fed continues its battle against inflation.
- Despite that record-level terminal rate, stock valuations have not fallen further. In fact, they’ve bounced well off their lows seen in early October. The last time S&P 500 Index valuations were at this level—April 2022—the expectation for peak rates was just 3.3%, almost 200 basis points lower than it is today.
Certainly, there are good reasons for the recent stock market rally. For one, Fed policy is better balanced than it was early last year, when inflation was surging due to the Russia-Ukraine War. Interest rate volatility is also lower today, which is helpful for asset valuations overall. That said, Fed policy still matters when it comes to stock valuations—and right now, that policy remains to raise rates until inflation is truly tamed.
In that environment, the S&P 500 Index at its current valuation may struggle to outperform—particularly if future earnings growth disappoints.
Our conclusion: We are increasing exposure to risk assets in the portfolios in a measured way by focusing on areas of the market we believe offer the most attractive risk/reward balance—such as international stocks—and underweighting those that may have come too far, too fast in a world where the expected cost of capital remains high.
This commentary is written by Horizon Investments’ asset management team.
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