Valuations. Valuations are the prices investors are willing to pay for those earnings. Here, we can do some analysis. In theory, valuations should vary with interest rates, with higher rates meaning lower valuations. Looking at history, this relationship holds in the real data. When we look at valuations, we need to look at interest rates. If rates hold, so should current valuations. If rates rise further, valuations may decline.
While the Fed is expected to keep raising rates, those increases are already priced into the market. Rates would need to rise more than expected to cause additional market declines. On the contrary, it appears rate increases may be stabilizing as economic growth slows. One sign of this comes from the yield on the 10-year U.S. Treasury note. Despite a recent spike, the rate is heading back to around 3 percent, suggesting rates may be stabilizing. If rates stabilize, so will valuations—and so will markets.
In addition to these effects of Fed policy, rising earnings from a growing economy will offset any potential declines and will provide an opportunity for growth during the second half of the year. Just as with the economy, much of the damage to the markets has been done, so the second half of the year will likely be better than the first.
The Headlines
Now, back to the headlines. The headlines have hit expectations much harder than the fundamentals, which have knocked markets hard. As the Fed spoke out about raising rates, and then raised them, markets fell further. It was a tough start to the year.
But as we move into the second half of 2022, despite the headlines and the rate increases, the economic fundamentals remain sound. Valuations are now much lower than they were and are showing signs of stabilizing. Even the headline risks (i.e., inflation and war) are showing signs of stabilizing and may get better. We may be close to the point of maximum perceived risk. This means most of the damage has likely been done and that the downside risk for the second half has been largely incorporated.
Slowing, But Growing
That is not to say there are no risks. But those risks are unlikely to keep knocking markets down. We don’t need great news for the second half to be better—only less bad news. And if we do get good news? That could lead to even better results for markets.
Overall, the second half of the year should be better than the first. Growth will likely slow, but keep going. The Fed will keep raising rates, but maybe slower than expected. And that combination should keep growth going in the economy and in the markets. It probably won’t be a great finish to the year, but it will be much better overall than we have seen so far.
Brad McMillan is the chief investment officer at Commonwealth Financial Network.