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Rising Interest Rates Will Continue to Challenge Market Returns

Despite a more tenuous global backdrop, the prospects for the U.S. economy remain positive. This strength also presents a challenge for expected market returns as strong U.S. economic momentum supports the case for a higher interest rate environment that we believe will inevitably limit total market returns. Our view takes into account the fact that cash flow-based valuation incorporates a “discounting” mechanism for stocks and bonds that is directly tied to interest rate levels. Intrinsic value is calculated by projecting out future free cash flows and discounting them back to the present. In its most basic form, lower rates help support higher valuation and higher interest rates drive valuation results lower. While interest rates alone are not the single factor that drives market returns, it does present a significant variable and construct that affects the price of stocks and bonds.

This tug of war between rates and valuation is best reflected in the recent pullback of the S&P 500, where valuation (based on a forward 12-month P/E multiple) has compressed from a FTM P/E of 18X-19X down to its current level of 16X-17X (Exhibit 1). Over this same period, we have seen the U.S. 10-year Treasury yield rise from below 3.0% to a more normal level above 3.0% (Exhibit 1). Consider that since 2000 the average yield for the 10-year U.S. Treasury is 3.49%.

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The Balancing Act of a Strong U.S. Economy and Rising Interest Rates

Looking ahead, we see a sustained path for higher interest rates as current economic conditions in the U.S. remain robust. Accordingly, we expect the Federal Reserve to stay on course with its tightening efforts as it attempts to balance growth against inflationary risks. Over the long-term, we believe that this balancing act and path to higher interest rates present incremental risks.

Specifically, a higher interest rate environment could eventually spill into consumer sentiment and spending (the single largest driver of the U.S. economy). On this front we note exposure to rising total consumer debt outstanding, which now stands at nearly $4 trillion (Exhibit 2). Similarly, a higher interest rate environment could raise challenges for the U.S. government as its debt-encumbered approach could weigh on economic growth with U.S. federal debt now at 103% of GDP (Exhibit 2).

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Despite Volatility, Our Approach Is Unchanged

A higher interest rate environment will likely result in further market volatility as the discounting mechanism for valuation incrementally adjusts expectations. Despite a more volatile backdrop, fundamentals matter over time. Our investment approach remains focused on:

·         Identifying client risk tolerances, investment objectives, and cash flow needs.

·         Developing intentional (purposeful) portfolios based on the above client goals, as well as asset valuation metrics.

Pursuing risk diversification through strategic asset allocation across equities, fixed income, and cash.

Julio C. Quinteros, Jr.