About the Author: Ashwin Alanker is the head of global asset allocation at Janus Henderson Investors.
The recent market trend of framing new developments in a negative light was helped earlier this month when the 2-year US Treasury note yield briefly rose above the 10-year yield. This was the first reversal between these two maturities since a blink during the height of the US-China trade war in 2019. Right on cue, the bears came out of hibernation, announcing an impending recession. The driver of the inversion was the Fed’s turnaround as it grapples with core inflation of 6.4% year over year. With the US central bank having more than doubled its own expectations for the number of 25 basis point rate hikes in 2022, from three last December to seven at its March meeting, investors were concerned that the Fed lived up to its reputation as the Expansion Killer.
We interpret the inverted yield curve differently. Much of the market’s consternation is based on the idea that the Fed has lost credibility due to its blatantly poor decision on temporary changes. inflation and deflecting its dual mandate by also prioritizing asset prices. But if the market thought the Fed had really lost its way, we would now be seeing a steepening, not flattening, yield curve. The fact that yield increases on Treasurys with maturities of 5 years or more have not kept pace with those of 2 years, in our view, means that the market believes that the Fed’s approach to controlling inflation is believable. Even factoring in the Fed’s new inflation-fighting skills, futures markets imply that real rates (nominal yields minus inflation) will remain very accommodative, likely well below 1.0%. Implicit in these market signals is the idea that the Fed must not only make strides in fighting inflation, but can do so without condemning the US economy to a certain recession while it carefully begins to slam on the brakes. of the economy.
When “bad” news is actually “good”
While the yield curve may have a notorious reputation among market bulls, this bearish predictor, along with other leading indicators, often misses the mark. Still, the logic of a reversal signaling a cooling economy is clear: Facing inflationary pressure, a central bank raises policy rates, which, in turn, raises short-term Treasury yields. , since these values are more tied to the official rate. The higher cost of capital for households and corporations as a result of higher rates should limit future economic activity. Lower economic growth is then reflected in falling yields on longer-dated Treasury bonds. If short-term borrowing costs are expected to rise too high, the yield curve may invert as investors brace for recession.
Currently, we believe that the flat yield curve reflects something very different from the recession. Rather, it suggests that the market appears to be taking the Fed’s word for it. The roughly 2.5% in the 2-year note is, if anything, perhaps a bit less than we would expect to see if the Fed follows through on its recent forecast of increase rates by a further nine to 10 times between now and the end of 2023. In addition, the sizeable gap that emerged between the Fed’s forecasts and futures markets’ expectations of rate hikes as the Inflation has slowed in recent weeks. Shorter-term inflation expectations have fallen more than 100 bps from their peaks, and longer-term expectations covering the period from 2027 to 2032 have remained anchored near 2.5%. All of this leads us to believe that the market believes the Fed has a fighting chance to control prices and thus contain the rise in long-term interest rates leading to a flatter near-inverted yield curve. . And here’s what you want to see: The Fed’s plan to raise short-term rates keeps long-term inflation expectations in check. This “investment” is “good”.
To be sure, the main driver behind the yield curve inversion is the speed at which shorter-dated Treasuries have priced into the Fed’s aggressive pivot. Other asset classes have not been immune. In addition to mid-term Treasury bonds falling 5% year-to-date through April 6 (an 18% annualized pace), rate-sensitive growth stocks, as measured by the Russell 1000 Growth Index , have fallen more than 11%, far exceeding the recorded losses. in broader US stocks.
The market has long known that the Fed will eventually policy must be changed. What he did not expect was how soon the regime change would occur and how pronounced the shift from extreme quantitative easing to very real quantitative tightening would be. Being caught off guard at such moments is what leads to tail risk events defined by four to five standard deviation movements in asset prices as investors scramble to adjust models for a cost of investment. materially higher capital.
This change marks the end of the era of extremely cheap money. But here too perspective is needed. Real rates, the main determinant influencing corporate and household borrowing decisions, remain negative in most of the developed world, with a range of -0.17% in the US, Germany and the UK , respectively. Shorter-term real yields are more entrenched in negative territory as they reflect strong near-term inflationary pressure. These levels hardly qualify as tight money.
Inflation may continue to surprise. There is certainly a lot of firewood. The supply chain disruptions of the pandemic era have yet to fully ease. Corporations and governments are inching toward the likely inflationary trend of deglobalization. Labor markets remain tight. And the war in Ukraine has disrupted commodity markets. Any of these could affect the pace of the Fed’s tightening and thus the path of real rates.
Remove a tailwind from stocks
More than a decade of easy money has benefited stocks in many ways. It lowered the cost of capital, allowing companies to finance deals, share buybacks, and acquisitions cheaply. It incentivized investors to seek yield, which pushed up share prices. And a low discount rate raised the present value of the cash flows that companies expected to generate in future years. Inevitably, the raw math of stock valuation causes the present value of future cash flows to decline as interest rates rise. With the value and demand for these future cash flows poised to decline, the premium that stocks, especially higher-growth stocks, command will likely fall.
In the years between 2003 and 2007, roughly the period between the technological implosion and the global financial crisis (GFC), the real yield on 10-year Treasuries averaged 2.04% and the price-earnings ratio (P /E) S&P Forward Median 500 Index came in at 16.3. From 2008 through the end of 2021, the index’s P/E ratio averaged 16.8, while the real yield on 10-year bonds stood at 0.39%. For growth stocks, the P/E expansion was more notable, averaging 17.4 before the GFC and 20.5 after. For stocks as a whole, the multiple expansion accelerated as real rates fell deep into negative territory after the onset of the COVID-19 pandemic.
The party is largely over. In line with rising expectations of policy tightening, the S&P 500’s 2022 full-year P/E ratio has compressed about 9% year-to-date to 19.8. The multiple for the pure growth component of the S&P 500 has contracted 19% more severely. How much lower can the multiples go? That depends on the path the Federal Reserve ultimately takes. What is certain is that many equity segments will continue to experience multiple compression as real rates move into positive territory.
Just one piece of the puzzle
Stocks losing the support of buoyant valuation multiples does not mean that everything is a disaster for stocks. There are other factors that influence stock performance. Implicit in lower long-term bond yields is a slowing economy. Companies that can grow earnings faster than the economy can expand would still get a premium, supporting their multiples. There are many candidates to generate such growth. While much of the technology sector is among the best valued in the broader market, the transformative secular themes behind many of these companies remain intact. Once valuations digest the painful adjustment to a tightening regime, many of these companies with dominant positions in growth markets will deserve another look.
Other growth segments include the global drive towards decarbonization and the reconfiguration of supply chains as major regions of the world look to localize key industrial inputs. These examples should serve as a reminder that stock valuations can become more attractive not only through multiple compression, but also when companies demonstrate that they can grow at high multiples by increasing earnings faster than the market expects. .
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