Rates vs. Earnings: Who's in Charge?

DEWITT, Mich. - Jan. 26, 2022 - PRLog -- If 2022 is out to make a case that it's not its older sibling, it's off to a good start. 2021 boasted attractive features like a 29% stock-market return, a single 5% dip that lasted a mere 20 days, 10-year interest rates that averaged 1.4%, a fed funds target rate of 0% accompanied by a $1.4 trillion increase in the Fed's balance sheet (stimulus), and a nearly 50% rise in corporate profits¹. Three weeks into 2022, the S&P 500 has dropped more than 6%, as 10-year rates have risen from 1.5% to as high as 1.9% (a two-year high), while the Fed is expected to end bond purchases this quarter and hike the fed funds rate as many as four times this year¹.

Despite these seemingly stark differences, we think this is an adjustment period, not an about-face.  Stocks will take some time to acclimate to a new climate that is absent emergency-level Fed liquidity. We think the recent volatility is consistent with this transition, reflecting a fairly normal response as equities begin to price in an accelerated timeline and magnitude for Fed tightening this year. We doubt this recalibration is complete, and we expect equities to remain on edge as interest rate keep a firm grip on the wheel in the near term.  Fortunately, the profit cycle is not at an exhaustion point, meaning the broader path in 2022 still looks to be a positive one.  As markets digest the new interest-rate regime, we think corporate earnings will slide into the driver's seat to steer equities to moderate gains this year.

Rising Rates: Lowering the volume, not turning off the music

• Not as much where rates are, but how they got here. Ten-year Treasury yields touched 1.9% last week before settling back by week's end1. While rates are still quite low by historical standards, it's the trajectory of the move that has rattled equity markets, as rates rose more than 0.5% since early December¹. We saw similar rate episodes last year, which included a 0.7% spike between January and March, and another 0.5% jump between August and October¹. The January-to-March episode sparked separate 3.5% and 4.2% pullbacks in the stock market, but ultimately saw equities rise 7.4% during that period¹. The rising-rate phase that fall prompted a 5.2% drop in stocks, but a gain of 2.8% over the period¹. We think a similar experience is transpiring currently, with equities likely to endure a choppy but temporary pullback as longer-term rates shift to reflect inflation pressures and tighter Fed policy.

Source: Bloomberg, the S&P 500 is an unmanaged index and cannot be invested in directly.