About the author: Ashwin Alankar is Head of Global Asset Allocation at Janus Henderson Investors.
The recent market trend to cast new developments in a negative light received support earlier this month when the US 2-year Treasury yield briefly rose above the 10-year yield. This was the first inversion between these two maturities since a blip during the height of the US-China trade war in 2019. As if on cue, the bears emerged from hibernation, ushering in an impending recession. The driver of the inversion was the Federal Reserve’s hawkish reversal, which is struggling with core inflation at 6.4% yoy. After the Federal Reserve more than doubled its own expectations for the number of rate hikes by 25 basis points in 2022 – from three last December to seven at its March meeting – there were growing concerns among investors that the Fed could live up to its reputation as a Fed would meet killer extensions.
We interpret the inverted yield curve differently. Much of the market’s consternation stems from the notion that the Fed has lost credibility because it is patently misreading transitory inflation and is losing sight of its dual mandate of also prioritizing asset prices. But if the market thought the Fed was really lost, we would now be seeing a steeper – not flatter – yield curve. The fact that yield increases on 5-year and longer Treasuries have not kept pace with 2-year maturities suggests, in our view, that the market sees credibility in the Fed’s approach to controlling inflation. Even factoring in the Fed’s newfound anti-inflation measures, futures markets suggest that real interest rates – nominal yields minus inflation – will remain very accommodative – likely well below 1.0%. These market signals imply the idea that not only should the Fed make strides in fighting inflation, but it can do so without condemning the US economy to some degree of recession as it begins to cautiously put on the brakes on the economy .
When “bad” news is actually “good”.
While the yield curve may have a notorious reputation among market bulls, this indicator of gloomy sentiment – along with other leading indicators – often misses the mark. Still, the logic for an inversion signaling a slowdown in the economy is clear: in the face of inflationary pressures, a central bank will raise interest rates, which in turn will push up yields on short-dated government bonds as these securities are more tied to the official interest rate. The higher cost of capital for households and businesses resulting from higher interest rates is likely to constrain future economic activity. Lower economic growth is then reflected in falling yields on longer-dated Treasuries. If short-term borrowing costs are expected to rise too much, the yield curve may invert as investors prepare for a recession.
For now, we believe the flat yield curve reflects something very different than a recession. Rather, it suggests that the market appears to be taking the Fed at its word. The roughly 2.5% on the 2-year note is perhaps a little less, if anything, than we would expect if the Fed lives up to its recent forecast of 9 to 10 more rate hikes between now and the end of 2023. That, too The significant gap that has opened up between Fed forecasts and futures markets’ rate hike expectations amid accelerating inflation has narrowed in recent weeks. Shorter-term inflation expectations have fallen more than 100 basis points from their peaks, and longer-term expectations for the period 2027-2032 have remained anchored near 2.5%. All of this leads us to believe that the market believes that the Fed has a good chance of reining in prices and thus stemming the rise in longer-term interest rates, resulting in a flatter, near-inverted yield curve. And here’s what you want to see – the Fed’s plan to raise short-term interest rates is keeping long-term inflation expectations in check. This “reversal” is “good”.
regime change
Certainly the main reason for the yield curve inversion is the speed with which shorter-dated Treasuries have priced in the Fed’s radical pivot. Other asset classes were not immune. In addition to mid-range Treasuries, which are down 5% year-to-date through April 6 (down 18% on an annualized basis), rate-sensitive growth stocks, as measured by the Russell 1000 Growth Index, are down over 11%, far beating losses registered in broader US stocks.
The market has long known that the Fed will eventually have to change policy. What was not anticipated was how quickly 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 leads to tail risk events, defined by four to five standard deviation movements in asset prices, as investors scramble to adjust models for much higher costs of capital.
This shift marks the end of the ultra-cheap money era. But perspective is also required here. Real interest rates – the key determinant in influencing business and household lending decisions – remain negative in most developed countries, ranging from -0.17% in the restrictive US (measured on 10-year Treasuries) to -2.3% and -2.7% in the United States Germany and Great Britain respectively. Short-term real yields are more deeply rooted in negative territory as they reflect acute near-term inflationary pressures. These levels are hardly considered tight money.
Inflation could continue to surprise. There is definitely plenty of kindling. Supply chain disruptions during the pandemic have yet to be fully mitigated. Businesses and governments are approaching the likely inflationary trend of deglobalization. The labor markets remain tight. And the war in Ukraine has turned commodity markets upside down. All of this could affect the pace of the Fed’s tightening and hence the path of real interest rates.
Eliminate a stock tailwind
See also
A decade plus of easy money has benefited stocks in myriad ways. It lowered the cost of capital and allowed companies to fund operations, stock buybacks, and acquisitions cheaply. It spurred investors to seek yield, driving stock prices higher. And a low discount rate increased the present value of the cash flows companies are expected to generate for years to come. It’s inevitable that the sheer math of stock valuation will cause the present value of future cash flows to fall as interest rates rise. As the value — and demand — of that future cash flow falls, the premium that stocks earn — particularly those of the fastest-growing variety — is likely to fall.
From 2003 to 2007, roughly the period between the tech implosion and the global financial crisis (GFC), the real yield on 10-year government bonds averaged 2.04% and the S&P median price-to-earnings (P/E) ratio 500 index stood at 16.3. From 2008 to the end of 2021, the index’s P/E ratio averaged 16.8, while the 10-year real yield fluctuated at 0.39%. For growth stocks, the P/E expansion has been more notable, averaging 17.4 before the GFC and 20.5 after. For equities as a whole, multiple expansions were accelerated as real interest rates plunged deep into negative territory following the outbreak of the COVID-19 pandemic.
The party is pretty much over. In step with rising expectations of monetary tightening, the S&P 500’s full-year 2022 P/E is down around 9% year-to-date to 19.8. The multiple for the pure growth component of the S&P 500 has shrunk 19% more. How much lower can multiples go? That depends on which route the Fed ultimately takes. What is certain is that many equity segments will continue to experience multiple compression as real interest rates move into positive territory.
Just one piece of the puzzle
That stocks are losing support from buoyant valuation multiples doesn’t mean all is doomed for stocks. There are other factors that influence stock performance. Lower long-term bond yields imply a slowing economy. Companies that can grow profits faster than the economy can expand would still charge a premium, thereby supporting their multiples. There are many candidates for such growth. While much of the technology sector is among the highest valued in the broader market, the transformative secular themes behind many of these companies remain intact. Once valuations have digested the painful adjustment to a tightening regime, many of these companies with dominant positions in growing markets will merit another look.
Other growth segments include the global push towards decarbonization and supply chain reconfiguration as large regions of the world seek to localize key industrial inputs. These examples should serve as a reminder that not only can stock valuations become more attractive through multiple compression, but also through companies proving that they can grow into elevated multiples by growing earnings faster than the market expects.
Opinions like this are written by writers outside of the newsrooms at Barron’s and MarketWatch. They reflect the perspective and opinion of the authors. Send suggested comments and other feedback to [email protected].
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