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Equity prices currently reflect expectations of higher bond yields and slower growth – an incongruous pairing. To a significant extent, the relative valuations of cyclical and defensive stocks, and also the price-to-earnings ratio for the S&P 500 as a whole, already reflect a stagflationary environment.

Since 2013, the most reliable indicator for equity returns has been real interest rates, thanks to interventionist central banks and a steady flow of investment assets from fixed income to stocks.

Equity returns vs. real interest rates

S&P 500 forward

P/E ratio

10-year TIPS

yield (inverted)

28

-1.5%

26

-1.0

24

-0.5

22

20

0.0

18

0.5

16

1.0

14

12

1.5

2017

2018

2019

2020

2021

the globe and mail, source: scott barlow;

bloomberg

Equity returns vs. real interest rates

S&P 500 forward P/E ratio

10-year TIPS yield (inverted)

28

-1.5%

26

-1.0

24

-0.5

22

20

0.0

18

0.5

16

1.0

14

12

1.5

2017

2018

2019

2020

2021

the globe and mail, source: scott barlow; bloomberg

Equity returns vs. real interest rates

S&P 500 forward P/E ratio

10-year TIPS yield (inverted)

28

-1.5%

26

-1.0

24

-0.5

22

20

0.0

18

0.5

16

1.0

14

12

1.5

2017

2018

2019

2020

2021

the globe and mail, source: scott barlow; bloomberg

The first accompanying chart illustrates how this has worked. (Note that inflation-adjusted yields are plotted inversely to better show the trend). S&P 500 valuation levels have climbed as real rates have dropped. This makes perfect sense in that real 10-year bond yields turned negative in March of 2020, indicating investors would lose money annually once inflation was considered. In response, assets flowed into equities, driving P/E ratios higher.

Inflation is here and rate hikes are coming. How should investors get through this changing landscape?

How are Canadian portfolio managers preparing for higher interest rates?

Inflation-adjusted yields have remained deeply in negative territory near minus 1 per cent, but P/E ratios have fallen, opening up a divergence on the chart. The chart’s final data points indicate that, if the correlation with P/E ratios were still intact, real yields should be near minus 0.4 per cent.

The divergence suggests that relative sector P/E ratios anticipate slower U.S. economic and profit growth along with higher rates when historically, yields and economic growth have been positively correlated.

Cyclicals have already been de-rated

Cyclicals/defensives:

Relative 12-mo. fwd. P/E

(6-mo. lead)

U.S. ISM

Manufacturing PMI

75

1.2

70

1.1

65

1.0

60

0.9

55

50

0.8

45

0.7

40

0.6

35

0.5

30

‘98

‘00

‘02

‘04

‘06

‘08

‘10

‘12

‘14

‘16

‘18

‘20

‘22

THE GLOBE AND MAIL, SOURCE: EXANE BNP

PARIBAS RESEARCH

Cyclicals have already been de-rated

Cyclicals/defensives:

Relative 12-mo. fwd. P/E

(6-mo. lead)

U.S. ISM Manufacturing PMI

75

1.2

70

1.1

65

1.0

60

0.9

55

50

0.8

45

0.7

40

0.6

35

0.5

30

‘98

‘00

‘02

‘04

‘06

‘08

‘10

‘12

‘14

‘16

‘18

‘20

‘22

THE GLOBE AND MAIL, SOURCE: EXANE BNP PARIBAS RESEARCH

Cyclicals have already been de-rated

Cyclicals/defensives: Relative 12-mo.

fwd. P/E (6-mo. lead)

U.S. ISM Manufacturing PMI

75

1.2

70

1.1

65

1.0

60

0.9

55

50

0.8

45

0.7

40

0.6

35

0.5

30

‘98

‘00

‘02

‘04

‘06

‘08

‘10

‘12

‘14

‘16

‘18

‘20

‘22

THE GLOBE AND MAIL, SOURCE: EXANE BNP PARIBAS RESEARCH

The second chart, developed by Exane BNP Paribas strategist Dennis Jose, is among the most interesting I’ve seen in a long time. Mr. Jose has uncovered a multidecade relationship between the relative P/E ratios of cyclical and defensive market sectors and the future of U.S. manufacturing activity.

It’s important to note that the strategist does not include technology stocks in his cyclical sector analysis. Conventional cyclical indexes do include technology stocks as cyclical but I think recent market activity has shown that this doesn’t make sense.

There are information technology subsectors, like productivity-oriented software, that remain sensitive to economic activity because as business activity boosts corporate profitability, companies have more money to spend on technology. However, the mega cap technology stocks that dominate technology indexes now – Facebook Inc., Alphabet Inc. , Netflix Inc., Microsoft Corp. and Adobe Systems Inc. are good examples – have often performed in a counter-cyclical pattern.

The outperformance of largest tech companies during the pandemic, when economic growth was cratering, is a strong recent example of why I agree with Mr. Jose that technology stocks should not be included among cyclical stocks.

Back to the chart. The blue line shows the relative P/E ratios of cyclical and defensive stocks – a falling line indicates that cyclical stock valuations are declining relative to defensives. The burgundy line plots the U.S. ISM Manufacturing Purchasing Managers Index, the most widely used gauge of American manufacturing activity.

Importantly, the blue line is pushed forward six months. The high correlation between these two lines implies that sector P/E ratios have consistently predicted manufacturing activity six months into the future.

Currently, valuations point to a dire short-term future for manufacturing activity. The last data points on the chart imply a contraction – a PMI reading below 50 – in activity in early 2022.

So, overall S&P 500 P/E ratios indicate higher bond yields and cyclical versus defensive P/E ratios forecast a slowing economy. This doesn’t leave a lot of sectors looking attractive. Higher rates will negatively affect defensive dividend payers and a slowing economy limits profits for economically sensitive companies.

Mr. Jose’s analysis implies that weakness in cyclical stocks is already reflected in valuations to some extent. Further downdrafts in these economically sensitive sectors could offer buying opportunities as a result.

High-quality stocks representing strong balance sheets and the steadiest, if unspectacular, profit growth seem to be the best option until more clarity on the outlook for later 2022 and 2023 arises. The strongest franchises in consistently growing sectors such as financials and health care fit the bill.

Scott Barlow is a market strategist for The Globe and Mail.

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