Even though earnings may rise, the real issue is rising interest rates. Supply and distribution issues are continuing to cause price and inflation pressures and higher inflation expectations however, markets appear to believe that more meaningful services, rent inflation and significantly higher bond rates are some way off.
Our position is that bond rates will rise through 2022 and 2023 and that the Fed will need to move their funds rate higher. So even though EPS growth is positive, the other side of performance is the valuation multiple and here the risks are on the downside, especially in a rising bond yield environment.
This is of course the basis of the rotation trade. High valuation multiples give way under a rising bond rate environment, but lower multiple companies with cyclical leverage to economic growth become relatively more attractive. We have seen ‘ebbs and flows’ in this supposed rotation over the last 6 months, largely tied to whether this inflation wave is transitory or not.
As I have noted, the inflation question is really one of whether services inflation emerges and flows into wages cost pressure. Markets seem more fixated on the supply side inflation, which leaves reasonably priced firms with cyclical leverage and solid earnings growth still not fully appreciated.
At Cameron Harrison, we find solving this paradox a necessary step for healthy and balanced equity returns, particularly for a US Equity Strategy. We continue to see firms such as Steel Dynamics (Nasdaq:STLD), Pulte Group (NYSE:PHM) or Archer Daniels Midlands (NYSE:ADM) that are exceptionally well conducted with low debt, significant free cash flow, robust earnings profiles and double-digit distribution returns. They are variously trading at less than 15x next year earnings with distribution yields in excess of 10% p.a. (noting – distribution yield is dividend + buy back).