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Welcome to RBC’s Markets in Motion podcast, recorded July 1, 2021. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Today in the podcast, we take a look at the historical playbook around Fed tapering and hiking, and what it means for our US equity market outlook.
The big things you need to know:
First, we’ve moved into the flattening camp on multiples, as Fed rate hikes – where the timetable has been pulled forward – are historically a headwind for forward P/E’s.
Second, while we don’t think these trades are done playing out yet, we think Fed tapering and rate hikes, and the cooling off of economic growth that’s already anticipated for 2023, put a potential expiration date on the rotation into Value, Cyclicals, and Small Caps. We are maintaining our overweights on Cyclical sectors (specifically Financials, Energy, and Materials) along with our preferences for Value over Growth and Small Cap over Large Cap for now as it seems far too early to flip the switch on these trades given the valuation room that we see in each of them, but we don’t disagree with the idea of narrowing these biases a bit in anticipation of an eventual shift.
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Now, let’s jump into the details.
Flip to slide 2 (PE and hikes)
Takeaway #1: our thoughts on the stock market’s P/E multiple, where we’ve moved into the flattening camp.
We have just moved up our S&P 500 EPS forecasts to $192 for 2021 and $216 for 2022, but there’s been no change to our 4,325 S&P 500 price target for 2021. With our new EPS forecast, our numbers imply that the S&P 500 will end the year at a 20x P/E based on 2022 EPS, up marginally from the 19.56x P/E that we believe the index ended 2020 at based on 2021 EPS.
We think this makes sense with Fed rate hikes on the horizon and the timetable being pulled forward, along with the possibility that investors will start pricing in rate hikes ahead of actual lift off.
We’ve recently taken some time to review the historical playbook around tapering and rate hikes. One of the lessons is that the S&P 500’s aggregate, or top down, P/E stumbles more often than not when the Fed is hiking rates.
When we calculate the P/E on the next full year of EPS (the equivalent calculation of today’s pricing on full-year 2022 EPS), we find that the multiple flattened, or chopped, around during the rate hikes of the mid 1990s, ahead of the Financial Crisis, and in 2017-2018.
Flip to slide 3 (P/E and Balance Sheet)
Previously, we’d argued that the P/E might expand a little this year to more than 21x, commensurate with the growth in the size of the Fed’s balance sheet that we’ve been seeing, since the market multiple has been trending with the size of the Fed’s balance sheet in recent years. But with the tapering timetable pulled forward, that no longer seems like a reasonable assumption to us.
Flip to slide 4 (baskets vs. Fed)
Moving on to takeaway #2: why we think the Fed, and the outlook for economic growth in 2023, may be putting an expiration date on the rotation that’s been underway in the market since last Fall into Cyclicals, Value, and Small Caps.
Something else the historical playbook tells us about US equities and the Fed is that Cyclicals tend to come under pressure relative to Secular Growth and Classic Defensives when the Fed is hiking rates.
Flip to slide 5 (Growth/Value vs. Fed)
Value also often comes under pressure relative to Growth, and Small Cap tends to come under pressure relative to Large Cap.
Flip to slide 6 (ISM vs. Fed)
I think that’s because Fed rate hikes also tend to be a mile marker for the economic cycle. We also tend to see ISM peak when the Fed is tightening,
Flip to slide 7 (GDP vs. Fed)
We also tend to see GDP shift to below average levels shortly after hikes conclude. And all of the trades I just mentioned tend to move in sync with ISM trends and whether or not the rate of change in GDP is above or below average. On GDP, it’s worth noting that consensus forecasts for real GDP are already tracking at 2.3%, below the 2.5% average, and that they’ve also moved down a little bit recently.
I think one of the things that the market is struggling with right now is that with a little more clarity on the Fed’s timetable, there’s clearly an end in sight for the Value rotation if history is any guide.
And what the GDP forecasts I just mentioned are also indicating is that by 2023 the GDP backdrop may no longer support the Cyclical, Value and Small Cap trades regardless of what the Fed does.
So, it’s tempting to say let’s just pull the plug on Cyclicals, Value, and Small Cap now.
Flip to slide 8 (Small/Large Fed performance)
But at the same time, the historical playbook also tells us not to get off these trades too early.
While Growth tends to have an edge during hikes and tapering, Value tends to have an edge leading up to them.
While Small Cap tends to experience a major peak relative to Large Cap during Fed hikes and tapering, Small Caps also tend to outperform Large Caps heading into those periods. And sometimes that relative performance peak happens near the end of the tightening period rather than at the beginning.
The story is similar for Cyclicals performance relative to Defensives and Secular Growth.
Flip to slide 9 (Small/Large Valuations)
Valuations in Value, Small Caps, and Cyclicals relative to Secular Growth are all still compelling.
Flip to slide 10 (GDP forecast trends)
And the economic runway to support these trades – real GDP well above average levels -- is also likely in place through the end of 2022.
So our bottom line message in terms of what to do is this – keep the overweights to Cyclicals, Value, and Small Cap for now, but narrow them a little bit.
In conclusion, I’ll just point out that while we’re only turning the dial away from the Cyclical Value trade a little bit today, this is a meaningful move for us. We’ve been fully on board the reflation train since January. We’re not getting off yet, but keeping an eye out for the right time to do so.
That’s all for now, thanks for listening, and please reach out to your RBC representative with any questions.