Inflation and its stickiness have recently been a persistent topic in news outlets. Measured against prices a year ago, inflation is at 3.5% as of the end of March. From a financial planning perspective, we feel it’s important to remember that we use the average rate if inflation over the past 50 years in our client’s financial plans. That’s higher than our current rate of inflation, meaning that the current rate of inflation doesn’t negatively impact to your financial plan’s projections.
The S&P 500’s year-to-date return is currently hovering around 7-8% as of April 24th (Yahoo finance April 24th 2024). That represents 70-80% of the average 12-month return, but in just 4 months. So, many may wonder why there has been a pull back from the all-time high in April of approximately 12%. Inflation, equity valuations, and geopolitical risks are key factors explaining this story.
While valuations of equities are affected by the interest rates set by the Federal Reserve through changes to the cost of borrowing, equity return expectations are also connected to the price to earnings ratio. The current P/E ratio for the S&P500 is at 21x as of March 31st 2024 (JP Morgan April 2024). Higher average P/E ratios subsequently have negative impacts on the future returns expectations on those equities. On both a 1 year and 5 year annualized return period, the line of best fit for P/E ratios shows that higher P/E ratios result in lower returns.
The Magnificent 7 (Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta and Tesla) have continued to make up the majority of the gains seen in the S&P500 year to date.
Though annualized inflation has fallen to 3.5% as of the end of March, this is still above the fed’s target of 2%, and inflation has proven stickier than previously expected. This is in part due to geopolitical issues that have affected everything from food to global shipping, but is also a result of a resilient U.S. economy which has not cooled down in response to higher interest rates as the Federal Reserve expected.
A stronger than expected economy has resulted in a higher long-term interest rate environment. Previous rate cut expectations have been pushed back as monthly economic data continues to support holding rates constant. Higher interest rates for longer periods of time affect the valuation of equities, which in turn has resulted in a decrease in their valuations because of higher borrowing costs.
Israel and Iran’s escalation did cause market volatility in the recent weeks, but from a multi-month perspective this should not be a major impact on markets holding the current conflict severity constant. Geopolitical conflict does impact markets, but generally has a shorter-term volatility compared to things such as interest rates.
To conclude, while the market has seen some pull back from it’s all-time high, the S&P 500 is still up 7-8% year-to-date, which is already 70-80% of it’s yearly average return since its inception in 1928. The P/E ratio of the S&P500 remains elevated at 21x, which correlates to lower expected annualized returns over a 5 year period. A higher for longer interest rate environment brought about by sticky inflation has led to further out rate cut expectations, which have affected the valuation of equities.
Jack O’Brien CIMA® is a Certified Investment Management Analyst educated at Chicago Booth School of Business and Virginia Tech. EVOadvisers is a fee-only financial advisor based in the Scott’s Addition area of Richmond, Virginia. EVOadvisers also has an office in Irvington, Virginia to better serve clients in the Northern Neck of Virginia. If you have any questions about financial planning and would like to talk with one of our Certified Financial Planner professionals, check us out at www.evoadvisers.com or call (804)794-1981.