Jim Solloway, Chief Market Strategist and Senior Portfolio Manager in SEI’s Portfolio Strategies Group, answers questions from Heather Corkery, Managing Director of Client Portfolio Management, in a two-part video series on the economic and investment outlook.

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Transcript

Heather: Hi, I’m Heather Corkery, Managing Director of Client Portfolio Management at SEI. We’re back with Jim Solloway, our Chief Market Strategist and Senior Portfolio Manager, to discuss what the evolving economic landscape means for investors.

Jim, we previously spoke about the prospect of lingering inflation and the likelihood that the Fed may need to hike interest rates higher and faster over the next few years than currently projected. How would you urge investors to think about the impact of rising rates?

Broad equity price movements have become increasingly tied to changes in benchmark interest rates. It’s an important relationship to understand, especially if we are reaching the end of the multi-decade bull market in bonds. 

Equities on a global basis are now tied to what happens in the U.S. bond market. To highlight it, we focused on the valuations of developed-market stocks outside of the U.S. based on their correlations with the 10-year U.S. Treasury bond. This chart shows the forward price-to-earnings ratio for the 20% of stocks that are most and least correlated to U.S. Treasury bond returns.

The 20% of the non-U.S. developed stock market with the highest correlation to Treasury returns now sports a forward PE that trades at a 70% premium to the PE of the overall U.S. market. The bottom 20% of non-U.S. developed stocks, on the other hand, trades at a 40% discount. This dispersion in valuation is extreme and highlights how big a driver the U.S. bond market has become for those stocks that have performed the best over the past decade.

We also found it helpful to see a side-by-side comparison of the most recent valuations on a country-by-country basis.

The U.S. stock market is not much different from the rest of the major markets when it comes to relative performance and extreme valuations. The bottom line is that investors appear convinced that interest rates will remain at rock-bottom levels for a long time to come.

But if bond yields push higher over time, the cohort of stocks most correlated with bonds could face a de-rating of their earnings multiples despite their solid company fundamentals.

Heather: We’ve been hearing a lot about the duration, or interest rate risk, embedded in expensive stocks. This really helps connect the dots between the two, and also showcases the relative opportunity in less-expensive stocks.

At a high level, how do you see the investment landscape shaping up over the next year or two?

Jim: We think there’s a lot to be optimistic about. The U.S. has been leading the way, but other advanced countries, notably in Europe, continue to post improvement in economic activity. The earnings of publicly traded companies remain robust and we believe that analysts might still be underestimating that strength.

We looked at the earnings growth rates of select countries and regions for 2020 alongside consensus estimates for the current calendar year and 2022.

With the exception of Japan, all earnings estimates for 2021 have been raised dramatically versus just six months ago. Forecasts for 2022 earnings have been cut in half from where they were six months ago, but they still are expected to show mid-to-high single-digit gains.

This lowering of the bar for next year could allow for upward revisions in analysts’ earnings estimates, assuming, as we do, that global economic growth gets back on track as vaccines are more widely distributed across the globe and the Delta variant fades into the background.

This doesn’t mean that markets will move upward in a straight line. We’ve already experienced a rise in market volatility in recent weeks. The energy situation in Europe is worrisome and could hurt consumer spending power. We also are tracking whether companies can maintain their ability to pass along higher costs to their customers. That said, we don’t see a global recession on the horizon, so any price correction in equity markets should be of limited scope and duration.

Heather: Thanks, Jim, for sharing these insights.

Jim: Thank you for the opportunity to talk to our clients.

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