The merciless sword of high interest rates strikes the US stock market. Will the long-cherished wish of "beating all" in performance be in vain?

Refusing to succumb to the highest US bond yields since 2007, global stock markets are now facing a new challenge: third-quarter earnings will reveal the extent to which the rising cost of borrowing, as the Federal Reserve raises benchmark interest rates to their highest level in 22 years - 5.25%-5.5%, will impact corporate profits and the valuation levels of the main driving force behind the bull market in US stocks - large-cap tech stocks.

Statistics show that against the backdrop of the Federal Reserve maintaining high interest rates for an extended period, approximately $820 billion worth of corporate bonds are set to mature in the next 12 months. At the same time, borrowing costs for companies in the S&P 500 index have reached their highest level in over 20 years. The "anchor of global asset pricing" has remained at a high level since 2007, and there is no doubt that these factors will impact the overall valuation level of the S&P 500 index.

The impact of high interest rates on US stock market earnings reports should not be underestimated!

As earnings season kicks off, corporate executives may be asked how long their balance sheets can withstand the pressure of high interest rates. Recently, Federal Reserve officials have frequently signaled "higher for longer," meaning that high interest rates will be maintained for an extended period. Generally speaking, the longer interest rates remain high, the longer the global "risk-free rate benchmark" - the 10-year US Treasury yield - will remain high, increasing the burden of debt refinancing. In addition, new projects may be forced to be postponed under the pressure of high interest rates, thereby reducing companies' investment scale for future growth.

Approximately $820 billion of US and European non-financial corporate bonds are set to mature in the next 12 months. According to data collected by Bloomberg, this accounts for about 7% of the market. Although overall, companies are not expected to face maturity obstacles until 2025, heavily indebted companies have already felt the pain of rising interest rates.

Patrick Armstrong, Chief Investment Officer at Plurimi Wealth, said, "For several quarters, the sword of Damocles has been hanging over highly indebted companies." "The latest earnings season may cause this sword to fall."

Moderate refinancing demand in 2024 - Company bonds maturing in 2024 account for 7% of the total market

Goldman Sachs strategists, led by David Kostin, recently warned that borrowing costs for companies in the S&P 500 index have reached the highest level in nearly 20 years. They noted that the return on equity (ROE) for the first half of this year contracted by 69 basis points, with nearly half of the decrease coming from increased interest expenses.

Since the global financial crisis, the decline in interest costs and the increase in leverage have accounted for nearly one-fifth of the 8.8 percentage point increase in ROE for S&P 500 index constituents. The strategists added that the risk of interest rates remaining high for an extended period could deter companies from increasing leverage, thereby impacting long-term profitability.

However, the basic prediction of David Kostin and other Goldman Sachs strategists is that the profitability of S&P 500 index constituents will bottom out this year and experience moderate expansion in 2024 and 2025. In a report last Friday, Kostin and the strategists wrote, "We expect profit margins for the S&P 500 index and most sectors to remain near 10-year highs." "While cost pressures and the easing of operating leverage should support profit margins, wage growth elasticity, rising interest rates, and taxes suggest that profit margins are unlikely to achieve significant growth."

Marija Veitmane, a senior multi-asset strategist at State Street Global Markets, stated that compared to industries tied to business cycles and economic growth, large-cap stocks in the robust balance sheet of the US stock market are a safer bet. "We expect a significant slowdown in the economy next year, so we may see management providing very conservative guidance," said strategist Veitmane.

As the "anchor of global asset pricing" flexes its muscles, will better-than-expected earnings reports become the "savior" of the US stock market?

The hope for a rebound in the bullish momentum of risk assets such as US stocks currently rests on the performance of "Beat All" - betting that exceeding earnings expectations is the most important influencing factor, surpassing any macroeconomic factors.

Large-cap stocks, especially highly valued large tech stocks in the US market, are currently facing the negative impact of higher interest rates. The high valuations of growth stocks like Nvidia (NVDA.US) and other tech stocks largely stem from strong profit expectations in the future. However, during a period of earnings vacuum, when the yield on 10-year US Treasury bonds, known as the "anchor of global asset pricing," surges, the valuations of these growth stocks will be severely suppressed, making them appear less attractive as investments.

At least one reason for the bullish forces hoping for the US stock market to emerge from its worst month in 2023 with optimism is that overall profits for S&P 500 index constituents are expected to rebound significantly starting in the fourth quarter. As the yield on 10-year US Treasury bonds, known as the "anchor of global asset pricing," soared (reaching the highest level since 2007 in October), the benchmark S&P 500 index experienced a two-month selling frenzy.The decline in September even reached nearly 5%.

From the perspective of the DCF model, although the 10-year US Treasury yield, which is equivalent to the denominator r indicator in the DCF valuation model, has reached its highest point since 2007 and remains stable at a high level, if the numerator cash flow expectation can continue to improve, it can greatly increase the pricing range of stocks and other risk assets, that is, increase the valuation level of risk assets. The numerator cash flow expectation is largely based on the performance of the earnings report season, so whether the company's profit can be revised upward, especially the earnings per share indicator, exceeding the general expectations of analysts, is crucial for the pricing trend of global risk assets such as stocks.

Currently, the expected price-to-earnings ratio of the Nasdaq 100 index, which is the benchmark for global technology stocks, is 23 times, 25% higher than the S&P 500 index, and the valuation of the S&P 500 index itself has been boosted by high valuations of technology stocks such as Nvidia, Tesla, and Meta. In terms of sales expectations, the price-to-sales ratio of the Nasdaq index is close to 4 times, almost twice that of the benchmark S&P 500 index.

Last week, a report by Manish Kabra, a strategist at Societe Generale, stated: "More than 70% of the valuation in the S&P 500 index is driven by long-term performance growth prospects. Therefore, when the anchor of global asset pricing during the performance vacuum period rises sharply in the short term, the US stock market often enters a downward trend due to valuation impact."

At the same time, the stock risk premium indicator, which measures the difference between expected returns on stocks and bonds, is being sharply squeezed, prompting investors to withdraw from the stock market. Emmanuel Cau, a strategist at Barclays, said: "In the scenario of long-term high interest rates in the future, changes in valuation levels are more important for stock market investors."

Therefore, with the official arrival of the earnings season, when S&P 500 index component companies gradually announce their Q3 actual performance and Q4 profit guidance, data that meets or even exceeds analysts' expectations is expected to greatly boost investor sentiment in the US stock market. For a stock market that persistently looks to the future, one of the bullish reasons is that the level of corporate profits will resume a growth trend starting in Q4 this year, which is also an important logic supporting the high valuations of large technology stocks such as Nvidia, Tesla, and Meta.Another important logic is that analysts' optimistic profit expectations for the S&P 500 component companies mean that the bullish trend in the US stock market is only a matter of time. From the perspective of long-term investment, with the market's recent aggressive pricing of high interest rate expectations, a significant pullback will create rare buying opportunities. Mark Newton, a global stock strategist at US investment firm Fundstrat, said on Tuesday that the US stock market is in the process of bottoming out, which means that investors may soon see perfect buying opportunities on dips.

In addition, according to the Bloomberg model, performance as a factor may have a greater impact on stock prices during earnings season than interest rates. The latest expected data compiled by research firm FactSet shows that Wall Street analysts generally expect the overall earnings per share (EPS) of the S&P 500 index to enter an upward trend.

Goldman Sachs recently stated that based on past situations, earnings season is likely to be a period of bountiful harvest for the US stock market, especially for tech giants. Goldman Sachs stated that history has shown that upcoming third-quarter earnings may catalyze a reversal in the momentum of large tech stocks, with the performance of large tech companies exceeding analysts' expectations in 81% of the time since the fourth quarter of 2016.

In terms of FactSet's statistical data, Wall Street analysts generally expect the overall EPS of the S&P 500 index component companies to decline by 0.3% YoY in the third quarter of this year, but revenue is expected to grow by 1.7% YoY. For the fourth quarter of 2023, analysts generally expect a significant increase of 7.8% YoY in EPS and a revenue growth of 3.9%. For the year 2023, analysts generally expect an EPS growth of 0.9% and a revenue growth of 2.4%. For the full year of 2024, analysts are extremely optimistic, with an expected YoY EPS growth of 12.2% and a revenue growth of 5.6%.