Why it’s not time to dump US equities: A Fed interest rate hike won’t drag down stocks

Throughout this recovery, we’ve longed to see more robust GDP growth, although modest growth so far hasn’t held back the magnitude or longevity of the six year equity bull market. This lack of runaway growth suggests that we’re only in the middle of the business cycle, rather than towards the end. In other words, if this is a much longer economic cycle than we’ve historically been used to, it’s likely we have a lot further to go on the upside, even if we only get there gradually.

 

The context hasn’t changed much when looking at whether US equities are too expensive. Doubts persist about whether they have reached the top of their potential, with uncertainty about the timing of the Fed interest rate hike acting as another reason for investors to consider taking money off the table. They should think again.

 

We don’t claim that this market looks inexpensive following several years of spectacular gains, but there are some significant reasons why valuations alone are not valid signs that investors should be taking profits or expecting a correction.

 

For example, many investors cite the current price to earnings (P/E) ratio on US equities looking stretched as a reason to bail out of the asset class. But let’s look a little closer. Even after returns of more than 200 per cent since the financial crisis, we’re currently on 17x P/E, which is about fair value. It doesn’t feel cheap, but the market isn’t demanding. We say that because, if we look at the history of 12 months returns after forward one-year earnings multiples, we can see the average annualised return in the next two years when the market is on 17x is 16.9 per cent, and over five years it’s 9 per cent annualised. It is not until the market gets to more than 20x that future returns begin to look challenged.

 

There is reason to believe that stronger US earnings growth will continue to support the market at these levels. In fact, our analysts predict average 4 per cent earnings growth this year (11 per cent if you strip out the energy sector, which is impacted by lower oil prices). Therefore, we don’t necessarily agree that US equity valuations look overly stretched.

 

We also need to consider the lessons of history when it comes to bear markets. If we define a bear market correction as a fall of 20 per cent or more, the S&P 500 has had 10 bear markets since 1926. Eight were caused by economic recessions or commodity shocks. Extreme valuations were a contributing factor in just four of the 10, many of which were exacerbated by other factors. In other words, valuations are very rarely the cause of the start of a bear market.

 

Finally, we challenge the notion that rising Fed interest rates could act as a negative drag on US dividend paying stocks. There is actually a positive correlation between rising interest rates and rising equity prices, when interest rates are rising from a low level. When interest rates are rising from a low base, there is a positive relationship between yield movements and equity returns on both the S&P 500 and the MSCI Europe index. The markets’ initial reaction to an interest rate hike tends to be a pullback reflex, but they then tend to revert back to a strong upward trajectory following a rate rise. Therefore, an interest rate hike in the context of a more healthy US economy is unlikely to derail shares.

 

The US equity bull market may be getting long in the tooth, but investors should reconsider before they rotate out of their US equities exposure. There are solid reasons to believe that the US party can continue for some time.