Economic Analysis: Main Street Finally Matters To Wall Street

Main Street Finally Matters to Wall Street
For the most part, the sluggish performance of the real economy since 2009 has provided a bullish backdrop for US equities, because the risks of the Fed having to abruptly reduce excessive monetary accommodation were commensurately reduced. Moreover, the struggles of Main Street were, rather perversely, often seen as good news for Wall Street, because a greater proportion of the rewards stemming from economic activity would flow through to corporate profits. The under payment of labour over the past two economic cycles was, therefore, seen as necessary, albeit unpleasant, condition to keep company earnings in the ascendency, particularly during the period of growing globalisation after 1993 which limited
The current 12-month forward S&P500 P/E multiple stands at 17.9, still way below its all-time peak of 25.2 reached in April 1999. Historically, the third hike in the federal funds has presented an obstacle for US equities, although these have not always been an insurmountable barrier for higher prices. Investors have taken the view that reflation and deregulation are sufficient offsets to higher interest rates via their purportedly beneficial impact on corporate profits. They need to pay attention to the 12-month forward S&P500 P/E multiple. Typically, during a Fed tightening cycle, this metric will peak before equity prices. Over the past 25 years, the time lag has varied between 11 months (1999-2000) to just 2 months in 2007. The bottom line is that Fed tightening has eventually ushered in the death knell of equity bull markets by firstly producing P/E multiple compression and subsequently lower equity prices. In the era prior to quantitative easing, the danger signal for equities typically occurred when the 12-month S&P500 prospective earnings yield minus the 10-year Treasury yield dipped below 170 basis points. Currently, this differential stands at just under 320 basis points, thereby implying, by historic standards, a sizeable buffer even as the Fed continues to normalise short-term interest rates. Investors need to be wary that yields on long-dated Treasury security securities are still being aided to the downside, courtesy of the Fed’s continued reinvestment of maturing principal on existing holdings. The cessation of this practice will help to normalise the behaviour of long-term interest rates, as well as helping to define the timing of peak of the S&P500 prospective P/E