Beyond the Headlines | 22 Sep 2023

Why a Fed pause won’t drive equities higher

Daniel Grosvenor

Director of Equity Strategy, Macro Forecasting & Analysis

Our latest video for asset managers

A peak in policy rates is often a positive catalyst for equities, but there are three key reasons why we don’t think it will be in this cycle.

In this week’s Beyond the Headlines, join Daniel Grosvenor, Director of Equity Strategy, as he discusses the implications of an end to the Fed’s hiking cycle.

Click here to check out previous Beyond the Headlines episodes.

Hi, I’m Daniel Grosvenor, Director of Equity Strategy at Oxford Economics. In this month’s equity allocation report, we discuss the implications of an end to the Fed’s hiking cycle. A peak in policy rates is often a positive catalyst for equities, but we think there are three key reasons why it won’t be in this cycle. First, we don’t expect swift rate cuts.

In his recent Jackson Hole speech, Jerome Powell made clear that the FOMC will keep rates in restrictive territory until it’s confident that inflation is moving sustainably towards its target. We believe that the Fed will remain on hold until next May, and we only forecast 75 basis points of rate cuts over the course of next year. Second, equity valuations are already extremely stretched.

Unlike the majority of previous Fed tightening cycles, P/E multiples have actually expanded over the past 12 months in advance of the peak in rates, and they’re now well above long-term averages. We think that leaves very little room for a further rerating. We think equities are particularly expensive when to the yields that are now available on safer assets. Our cross asset relative valuation indicator is currently at a level that has historically been consistent with equities underperforming bonds over a six- to 12-month horizon.

Third, we forecast further downside for earnings as profit margins remain under pressure. Our top-down models suggest that US earnings will fall by 7% this year and will not begin a sustained recovery until Q2 2024. We think this will provide an ongoing headwind for equities over the next couple of quarters, offsetting the support from lower yields. So overall, we think that equities will struggle to rally further despite a Fed pause.

We are underweight the asset class in our Global Asset Allocation and we remain relatively defensively positioned at the sector level.

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