Why Equity Multiples Expanded Despite Rate Hikes — And Why That May Be Ending

From March 2022 to July 2023, the Federal Reserve raised interest rates dramatically — from 0.25% to 5.50%. Traditional valuation models, like the Discounted Cash Flow (DCF) model, would suggest that such a sharp rise in interest rates should result in lower equity valuations.

But the opposite happened.

During that same period, the S&P 500 rose from 4,204 to 4,582, and the forward price-to-earnings (P/E) ratio increased from 18.7x to 21.2x. Clearly, something other than interest rates and DCF modeling was influencing stock valuations.

The Real Driver: Rising Profit Margins

We believe a secular shift in corporate profit margins has been a major driver of multiple expansion over the past 15 years.

The chart accompanying this post plots profit margins against forward P/E ratios, with the P/E data advanced by 18 months. The relationship is clear: rising profit margins have led to higher equity multiples.

The Global Trade Tailwind Is Fading

Unfortunately, one of the biggest contributors to margin expansion over the last decade and a half has been global trade — and that trend now appears to be stalling or reversing.

Between 2010 and 2024, global trade nearly doubled, growing from $16.7 trillion to $33.0 trillion. This globalization boom supported efficiency, scale, and profitability across sectors.

However, emerging trade policy shifts, geopolitical tensions, and onshoring initiatives are creating headwinds for global trade. As a result, companies may face margin pressure, and equity multiples — which have risen in tandem with margins — may begin to contract.

Conclusion: Prepare for a Shift in Market Drivers

As investors, it's important to look beyond interest rates and traditional valuation models. If global profit margins have peaked, we may be entering a new regime where multiple contraction, not expansion, becomes the dominant force — especially if global trade continues to decelerate.

Key Takeaways for Investors:

• Equity multiples expanded despite rising rates, defying DCF logic

• Profit margin expansion has closely tracked multiple growth

• Global trade was a key tailwind — now potentially turning into a headwind

• Investors should prepare for potential margin compression and valuation reset