Goldman Sachs analyst David Kostin, who has been in a bullish mood, showed a clear cautious tone in his recently released weekly report. He said that postponing or reducing interest rate cuts may not have a great impact on U.S. stocks, but if interest rates continue to rise sharply, U.S. stocks will be in big trouble.
Kostin said in the report that his optimistic estimate that the S&P 500 will close at 5,200 by the end of the year was questioned by many customers, as the market is already pricing in fewer and delayed Fed interest rate hikes. But on the one hand, the lack of rate cuts is not necessarily a game-changer in itself, and even in the face of rate hikes, the S&P 500 has returned 6% this year, just 4% below its all-time high of 5,254.
While continued tightening could weigh on price-to-earnings ratios, Kostin believes that "while our economists expect inflation to continue to slow, leading to a rate cut later this year, a delayed rate cut should limit equity valuations." Kostin believes earnings growth will allow the S&P 500 to grow by 3% by the end of the year, reaching his target of 5,200 points.
But the bad news is that even the consistently optimistic Kostin now expects that if interest rates continue to rise sharply, "equities will struggle to find their footing," regardless of macro drivers. In other words, if the latest Treasury "VaR shock" accelerates, even the AI narrative that currently underpins the market will collapse because it can't withstand the full pressure of the market.
Since 2006, the S&P 500 has fallen by an average of 4% when the yield on the 10-year Treasury note has risen by more than 2 standard deviations in a month, Kostin noted.
Today, a two-standard deviation increase in the real 10-year Treasury yield in one month equals about 55 basis points. This is also in line with historical trends, with real 10-year Treasury yields up 40 basis points and the S&P 500 down 4% since mid-March. A further rise in yields, especially if the 10-year Treasury yield exceeds the key level of 4.8%, as well as the continued equity market rally before that, will run into obstacles.
According to financial blog ZeroHedge, traders seem to be completely unaware that the market is currently in the midst of a brutal "VaR shock", with the 10-year Treasury yield rising 80 basis points since the beginning of the year and now hovering around 4.7%. This sharp increase is due to stubbornly high inflation and a return to the "keep rates high for longer" narrative, resulting in rate-sensitive areas of the market underperforming other sectors this year, such as unprofitable tech stocks, high beta, financially weak, and low free cash flow companies.
As for rising interest rates, Goldman Sachs thematic trader Louis Miller wrote that "due to the CTA (commodity trading advisor) sell-off, rising interest rates and commodity prices, the de-risking of some actively managed funds, geopolitics and whether this quarter's earnings can support year-to-date gains", U.S. equity returns are expected to be more selective and remain range-bound in the near term.
At the same time, in order to understand the impact of ongoing interest rate changes, Goldman Sachs analyzed the sharp rise in interest rates in the first half of 2022. Despite the different market performance in the two periods, such as the S&P 500 falling 20% in the first half of 2022 and up 5% year-to-date, Goldman Sachs has found that larger companies, strong balance sheets, high free cash flow, high earnings per share and low beta have outperformed other companies in both cases.
In any case, interest rates will continue to be in focus as the Treasury is due to release major macro data this week such as the refinancing package and the highly anticipated CPI data on May 15. If these events change the direction of interest rates, such as cooling inflation, then portfolios will be affected, with the Beta and Momentum factors being the most sensitive to changes in the 10-year Treasury yield.
If the 10-year Treasury yield falls back to the 4% level seen in December, beta-influenced stocks could rise by 10%, while Momentum-related stocks could fall by 10-14% after a brief rally. Conversely, if interest rates continue to rise gradually, Momentum may continue its winning streak, while Beta and the market may continue to slide, barring a major earnings or geopolitical surprise.
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