Higher rates are a headwind but not a wrecking ball, says Tony Pasquariello
The backdrop for equities is not as bearish as some market strategists would have you believe, says Golman Sachs strategist Tony Pasquariello
The S&P 500 has been in holding pattern for two months now, its progress stalled by bond-market carnage and its technicals undermined by the narrow breadth of stocks keeping up the index. For the head of Goldman Sachs' hedge fund coverage, this setup is not as bearish as many market commentators would have investors believe.
Tony Pasquariello acknowledges the trading environment is "certainly not uncomplicated" but still reckons the underlying trend is higher and the S&P 500 benchmark will end 2026 higher than it is today.
There are four key reasons why stock markets are not being complacent about higher rates and will end the year higher: strong economic growth, stellar earnings, supportive fund flows and the impetus provided by the AI capex boom.
Admittedly, given the S&P 500 SPX is within half a percent or so of its all-time high, Pasquariello's prediction is not wildly bullish. However, the Goldman veteran strikes a more positive tone than many market commentators who have been sounding the alarm after the surge in bond yields in September.
Surveying the fourth quarter, Pasquariello still identifies a "core bullish framework" and he regards technicals - like sentiment, positioning and seasonals - as supportive. In a desk note sent to clients Monday, Pasquariello agrees that chaotic bond markets have undermined equities, especially the rate-sensitive parts of the market like small-cap stocks RUT, homebuilders XHB, utilities XLU, real-estate investment trusts VNQ , biotech IBB and loss-making tech stocks.
Yet, he interprets the spike in bond yields BX:TMUBMUSD10Y as "a headwind rather than a wrecking ball." Moreover, far from being complacent about these risks, Pasquariello points out that the price-earnings multiple of the S&P 500 has derated from around 23 times to 19 times over the past year precisely owing to these higher yields. "Interest rates matter", he admits, "but so do profits" and the 27% third-quarter earnings per share growth he expects is "some form of terrific."
S&P earnings growth is still "some form of terrific" according to Pasquariello
Drilling down into that earnings growth, Pasquariello makes some interesting discoveries: Four-fifths of the growth comes from tech and energy stocks (which isn't surprising) but AI infrastructure stocks drive half of that growth and just two companies - Nvidia (NVDA) and Micron (MU) - generate one-third between them. To that end Pasquariello's advice is straightforward: stick with the fastest horses in the race that are supported by superb earnings growth.
While much of the debate around AI-related stocks over the past couple of years has focused on how much investors are paying for such rapid growth, the Goldman note reveals that the forward P-to-E multiple of the median AI play was 32 times back in April of this year but now it's 22 times.
Pasquariello tackles a couple of other caveats investors might cite about buying stocks here. First, while the S&P's present 19 times multiple puts it in the 76th percentile over the last 35 years, it's also the exact average of the last decade. Also, while bears have constantly cited narrow market breadth as a cause for concern, this has been the case throughout the last four years of this bull market.
The S&P 500 is actually trading in line with a long-established PE mutiple of 19x
Lastly, Pasquariello reassures investors insurance is not that expensive.
Volatility, as measured by 'the fear index' VIX VIX is languishing within a point of its low for the year meaning that "the cost of convexity is not prohibitive" by which he means it's relatively inexpensive to buy option-based protection.
-Jules Rimmer
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