Part 1 : room for growth in long-term rates
The Federal Reserve has gradually shifted its stance to prepare the markets for monetary tightening in 2022. The message has been heard and interest rate expectations adjusted. Markets are now pricing in five rate hikes in 2022 (Chart 1).
The first increase could take place in March, when the Fed ends its asset purchase program. However, the market continues to anticipate a very limited tightening cycle, with a terminal rate close to 2% (Chart 2), which seems too low.
While medium-term inflation expectations have picked up, they are still below the level that prevailed before their downturn in 2015, especially in the US. Real rates are still very negative (Chart 3). If the central bank wants to slow down the economy, it will have to bring them into positive territory.
The Fed could start reducing its balance sheet by the middle of the year. From 2018 to 2019, the balance sheet was reduced by USD 40 billion every month, at a time when the Fed did not particularly want to weigh on activity. In the current environment, the pace could be faster.
The minutes of the December meeting showed that a number of participants want to prevent the rise in short-term rates being accompanied by a reduction in long-term rates, which would reduce monetary policy transmission to the economy.
By reducing its balance sheet, the Fed will thus be able to act on the longer end of the curve, which not only reflects short-term rate expectations, but also a risk premium. This is currently close to zero, while it was close to 2% historically. The reduction in the Fed’s balance sheet creates the conditions for normalisation, which would be a driver of rate hikes.
On the credit side, corporate issuers’ positive fundamentals appear to be reflected in spreads near their lows (Chart 4). The impact on credit of the rise in interest rates will depend on its speed.
With regard to the spreads of peripheral countries, the approaching presidential election in Italy is a source of tension. If Mario Draghi were to be elected, he would have to find a successor as head of government, which may not be easy. This could potentially lead to new elections that could inaugurate a prolonged period of uncertainty, according to the polls.
Part 2 : what is the trajectory for equity markets?
Strong growth should continue to support corporate earnings. Expectations for 2022 look reasonable, estimated at around 7% overall.
As the rise in earnings was higher than that on equity markets over the past year, the 12-month Price to Earnings Ratio (PER) fell significantly, except in the US, where it remained broadly stable (Chart 5). While valuations appear a priori more reasonable compared to the 2015-2019 average, the US PER is 15% higher despite the recent correction. For eurozone equities, the premium is 4%. Emerging equities returned to the average level of this period and Japanese equities are trading at a discount.
Other indicators such as Price to Sales, for which more history is available than for the PER, show that the S&P 500 has never been more expensive (Chart 6). Cyclically adjusted data, which are long-term averages, also confirm the exceptional nature of the US. The US cyclically adjusted PER was only higher than the current level during the internet bubble (Chart 7). In Europe, this multiple is much lower. It is approaching the peak of the last 20 years, but is not at bubble level.
Equity market valuations remain attractive compared to bond markets. In the US, a rate hike of 100 basis points would, however, put the equity risk premium below the lows of the last ten years. Against a backdrop of upward pressure on interest rates, this indicator is therefore less relevant. Conversely, the correlation of the relative performance of cyclical stocks/growth stocks with real rates is confirmed and is an important element compared to other uncertainties.
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The opinion expressed above is dated January 2022 and is liable to change. Latest available data as of publication date.
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