Central banks are tightening, and stocks are still within reach of their highs. The Fed hiked on September 16 for the first time since 2023, and the 10-year Treasury yield touched 5.34% this month, its highest level since 2002. Even so, the S&P 500 sits within roughly 2.5% of its record, and Japanese equities recently set fresh all-time highs. Despite the concern around rising rates, we think equities can still deliver positive returns through year-end.
Since May, central banks in Australia, New Zealand, Europe and Japan have joined the Fed in raising rates, with the Riksbank and the Bank of England expected to follow. The Fed is unwinding the "insurance cuts" it made when the U.S. labor market wobbled late last year, a very different exercise from chasing runaway inflation. As long as volatility at the long end of the curve stays anchored, we believe staying overweight stocks versus bonds is the right call.
But don't stocks struggle when the Fed hikes? In the short run, maybe. Goldman Sachs looked at seven recent hiking cycles which saw the S&P 500 Index decline by 2% in the three months after the first hike. However, the market gained an average of 9% over the following 12 months, with positive 12-month returns in every cycle except 2022. Even in 1997, the extreme case, when the index fell 10% after a single 25 basis point (bp) hike, stocks bottomed once the market stopped pricing more tightening and reached new highs within three months.
While a sharp correction is not our base case, rising oil prices and U.S. rates may keep volatility elevated. That could offer chances to buy stocks at a discount, so know what you want to own before they show up.
In the current cycle, earnings matter more than rates. The S&P 500's forward P/E has compressed from 22x at the start of the year to 19x even as the index trades near its record, which means forward earnings estimates have lifted the market. Relative to bonds, stocks look about the same as they did a year ago: the gap between the S&P 500 earnings yield (5.2%) and the real 10-year Treasury yield (2.6%) is roughly 270 bps. Outside of brief drawdowns, it has held steady for two years signaling that investors have not demanded a bigger risk premium.
What is the ceiling on how high rates can rise before they start impacting equities? Many strategists will point to the “Fed Model”, which compares the earnings yield with the nominal 10-year yield, but we are less convinced by this relationship. Even so, it is true that equity multiples have tended to come under pressure as the 10-year approaches 5.5%.
See more: Worried Consumers Keep Spending: Here's Why
Going deeper, we think the speed of the move matters more than the level. Stocks have usually posted positive returns alongside rising yields unless the move was fast enough to upset the apple cart, which today works out to about 50 bps in a month or 30 bps in two weeks. September's Treasury selloff helps explain why stocks wobbled, and a broader hiking cycle that pushes long yields sharply higher would weaken the earnings anchor. In that setting, we would favor quality companies with high returns on equity and assets.
While markets may continue to climb the wall of worry as rates remain volatile, we think the U.S. economy and corporate earnings will continue to be strong. In that environment, we think stocks can continue to deliver respectable returns.
For more information, contact your WisdomTree representative or visit WisdomTree.com/us.
See the WisdomTree Glossary for definitions of terms and indexes.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund before investing. For a prospectus or, if available, the summary prospectus containing this and other important information about the Fund, call 866.909.9473 or visit WisdomTree.com/us. Read the prospectus or, if available, the summary prospectus carefully before investing.
Past performance does not guarantee future results.
Important Risk Information:
There are risks associated with investing, including the possible loss of principal. Foreign investing involves currency, political and economic risk. Funds focusing on a single country and/or sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Emerging markets, real estate, currency, fixed income and alternative investments include additional risks. Please see the prospectus for a discussion of risks.
This material contains the opinions of the authors, which are subject to change, and should not be considered or interpreted as a recommendation to participate in any particular trading strategy or deemed to be an offer or sale of any investment product, and it should not be relied on as such. There is no guarantee that any strategies discussed will work under all market conditions. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This material should not be relied upon as research or investment advice regarding any security in particular. The user of this information assumes the entire risk of any use made of the information provided herein.
Kevin Flanagan and Bradley Krom are Registered Representatives of Foreside Fund Services, LLC.
WisdomTree Funds are distributed by Foreside Fund Services, LLC.
A message from Advisor Perspectives and VettaFi: Discover something new! Click here to register for our upcoming webcasts.
© WisdomTree, Inc.
More ETF Topics >
