Amanda Agati:

In this edition of "#AddingAlpha," we take a look at the potential impact of rising inflation and interest rates on equity market valuation multiples.

We've been in a high-volatility regime really ever since the start of the pandemic, but it clearly has been quite a few months since investors have had to wrestle with the sharp downdrafts that can come in a high-volatility regime like this one.

Last year, believe it or not, the biggest drawdown in the S&P 500 was only 5 percent.

This year, the S&P 500 is now in the midst of its steepest drawdown since September of 2020 and as of this recording.

It's really being driven by a function of two things, one, the much more hawkish tone from the Fed, and what we mean by that is faster, more aggressive withdrawal of policy support really than the market consensus was expecting, and this applies to both tapering their balance sheet as well as raising policy interest rates, and, two, the sustained, elevated, inflationary readings that we've been getting more recently.

The Fed is reacting to these red-hot inflation readings in the near term, and so the market is starting to worry that potentially raising rates and tapering the balance sheet too fast could ultimately derail
this economic expansion, which is already starting to shift into a slower phase of the cycle.

We literally went from the projection of one to two rate hikes at most in 2020 to now at least four in about 45 days, and so as a result, the market is really struggling to quickly reprice the shift
in the near-term macro backdrop.

Even with the recent pullback, the S&P 500 still has a forward PE of about 20 times.

This is about five multiple points above its long-term average, and so it's really hard to argue, again, even with the reset that the market is cheap at these levels.

Unfortunately with regime changes often come multiple reratings, and these two charts help frame the potential magnitude of multiple compression ahead of us based on either sustained higher inflation levels of sustained higher interest rates with data going back to the 1950s.

If you take a closer look at the CPI chart with CPI running at about 7 percent year over year based on this analysis, the trailing 12-month PE should actually be somewhere in the neighborhood
of 13.8 times whereas the current or actual trailing 12-month PE for the S&P 500is 24 so a far cry from where we are today.

If you take a look at the relationship between multiples and a 10-year Treasury yield with the yield currently at about 1.8 percent, the trailing 12-month PE based on this analysis would be somewhere in the neighborhood of 24 to 25 times, actually pretty closely aligned with the current 24 on the S&P 500, so it's really this still favorable interest-rate backdrop that's supporting market multiples for the time being, but we're clearly at a crossroads as it relates to Fed policy.

When we look under the hood, earnings continue to be quite strong in the neighborhood of 8 percent for the S&P 500 in 2022 though a much slower pace of advancement than the 50 percent plus growth we're going to register for 2021, but in a market that's pricing for near perfection, it's not at all surprising to see volatility pick up here.

There's just not that much headroom or shock absorber when negative news comes into the narrative. At the end of the day, this is why we don't expect much in the way of tailwinds from additional multiple expansion this year.

We won't have record low interest rates or even relatively low inflation levels as key drivers for the market like they have been the last couple of years, and so it's really just the trajectory of earnings growth to keep this market rally alive.

Ultimately, the wild card in this projection is how hawkish the Fed decides to get in the months ahead.