Chart of the week

After Fed liftoff, fundamentals take center stage

As the Fed commences a new round of rate hikes, our chart looks at maximum compression in price/earnings (P/E) ratios amid historical rate hike cycles.

March 25, 2022 | 2 minute read

Max decline in forward P/E ration: 1 year before the first rate hike to 1 year after

Source: Bloomberg Finance, L.P., FS Investments, as of March 16, 2022. Data for 2022 runs through the first rate hike only.

  • Last week, the Fed announced the first in what will almost certainly be a prolonged series of rate hikes. After an initial 25 bps hike at their March 16 meeting, futures markets imply an expectation for 7–8 additional hikes in 2022.1
  • Against this backdrop, the yield curve flattened meaningfully as short-term rates have risen more than longer-term rates and stocks, especially higher duration growth stocks, fell as higher yields pressured discount rates.
  • The chart shows the maximum compression in price/earnings (P/E) ratios for the S&P 500 around the start of a rate hike cycle—from one year before the first hike to one year after. While the total drawdown in multiples has been fairly consistent across cycles at 2x–3.2x, the timing of equity market repricing has not.1
  • In fact, the current cycle has seen the sharpest pre-hike decline in valuations, consistent with the fact that markets aggressively priced in a hiking cycle, as evidenced by the soaring 2-year Treasury yield.
  • Now that the Fed has lifted off and the market has priced in tightening, market fundamentals take center stage. The backdrop for earnings remains rock solid despite inflation and rising rates. Earnings per share growth for the S&P 500 is expected to moderate from its pace of 2021, but still settle in at a healthy 7% and 10% in 2022 and 2023, respectively.1
  • Given the range of significant economic and market headwinds, however, the distribution of market outcomes remains extremely wide and traditional indexes could remain under pressure. While it is possible markets have seen the bulk of Fed-induced P/E compression, there is little precedent for valuations to improve markedly as the Fed hikes. Within this environment, investors may benefit by remaining flexible, willing and able to react to incoming data around the economy and earnings.

  • Bloomberg Finance, L.P., FS Investments, as of March 16, 2022. Data for 2022 runs through the first rate hike only.

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