About the author: Ashwin Alankar is Head of Global Asset Allocation at Janus Henderson Investors.
The market’s recent tendency to frame new developments in a negative light received some help earlier this month as the yield on the 2-year US government bond rose briefly above the 10-year. This was the first reversal between these two maturities since a blip during the height of the trade war between the United States and China in 2019. At the cue, bears came out of hibernation and called for an impending recession. The driving force behind the inversion was the Federal Reserve’s hawkish face as it struggles with 6.4% year-on-year core inflation. As the US Federal Reserve had 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 worried that the Fed would live up to its reputation as a killer of enlargement.
We interpret the reverse yield curve differently. Much of the market’s dismay is based on the idea that the Fed has lost credibility due to its sharply bad call for temporary inflation and take its eyes off its dual mandate by also prioritizing asset prices. But if the market thought the Fed had really lost weight, we would now be witnessing a steeper yield curve – not a flattening. The fact that interest rate hikes on government bonds with maturities of 5 years and longer have not kept pace with the 2-year means, in our view, that the market sees the Fed’s approach to controlling inflation as credible. Even taking into account the Fed’s newfound anti-inflationary chops, futures markets imply that real interest rates – nominal interest rates minus inflation – will remain very volatile – probably well below 1.0%. Implicit in these market signals is the idea that the Fed should not only make inroads in the fight against inflation, but that it can do so without condemning the US economy to a certain recession when it gently begins to put the brakes on the economy.
When “bad” news is actually “good”
While the yield curve may have a notorious reputation among market forces, this indicator of gloom – along with other leading indicators – often misses the mark. Yet the logic of an inversion signaling a cooling economy is clear: In the face of inflationary pressures, a central bank raises policy rates, which in turn pushes short-term government bond yields higher, as these securities are more tied to official interest rates. The higher cost of capital for households and businesses due to higher rates should limit future economic activity. Lower economic growth is then reflected in falling interest rates on longer-term government bonds. If short-term borrowing costs are expected to rise too aggressively, the yield curve may be reversed as investors prepare for recession.
At the moment, we believe that the flat yield curve reflects something completely different from recession. Rather, it suggests that the market seems to be taking the Fed at its word. The around 2.5% on the 2-year note is, if anything, perhaps a little less than what we would expect to see if the Fed follows up on its latest forecast of raising interest rates between nine and 10 times more between now and the end of 2023. Also, the significant gap that emerged between the Fed’s forecasts and interest rate hikes from futures markets as inflation accelerated has narrowed in recent weeks. Short-term inflation expectations have fallen above 100 bps from their peaks, and long-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 that the Fed has a huge chance of curbing prices, thus curbing the rise in long-term interest rates, leading to a flatter almost reverse yield curve. And that’s what you’ll see – the Fed’s plan to raise short-term interest rates keeps long-term inflation expectations in check. This “inversion” is “good”.
Change of regime
It is quite certain that the primary driving force behind the inversion of the yield curve is the rate at which shorter government bonds have priced the Fed’s high point. Other asset classes have not been immune. In addition to intermediate government bonds falling 5% year-on-date until April 6 (an 18% annual rate), price-sensitive growth stocks, measured by the Russell 1000 Growth Index, have slipped above 11%, far more than recorded losses. in broader US equities.
The market has long known that the Fed would eventually must change policy. What it did not expect was how quickly a regime change would occur and how pronounced the shift from extreme quantitative easing to very real quantitative tightening would be. Being taken aback in such moments is what leads to tail risk events as defined by four-to-five standard deviation movements in asset prices, while investors struggle to adjust models to significantly higher capital costs.
This shift marks the end of the era of extremely cheap money. But here, too, perspective is needed. Real interest rates – the most important factor in influencing corporate and household lending decisions – remain negative in most of the developed world, ranging from -0.17% in the high-yielding US (measured by 10-year government bonds) to -2.3% and -2.7% in Germany and the United Kingdom, respectively. Short-term real interest rates are more deeply rooted in negative territory, as they reflect acute short-term inflationary pressures. These levels hardly qualify as tight money.
Inflation may continue to surprise. There is definitely plenty of ignition. Interruptions in the supply chain from the pandemic are not yet entirely easy. Businesses and governments are heading towards the likely inflationary trend of deglobalization. Labor markets remain tight. And the war in Ukraine has turned up in the commodity markets. Any of these could affect the pace of Fed tightening and thus the path of real interest rates.
Removal of a stock tailwind
A decade plus of easy money has benefited stocks in a myriad of ways. It lowered capital costs, enabling companies to finance operations, stock repurchases and acquisitions cheaply. It encouraged investors to reach out for returns and thus bid up stock prices. And a low discount rate raised the present value of cash flows that companies are expected to generate in the coming years. It is inevitable that the raw mathematics of stock valuation will push the present value of future cash flows lower as interest rates rise. With the value of – and demand for – these future cash flows declining, the premium that stocks fetch – especially those of the growing variety – is likely to decline.
In the years from 2003 to 2007, roughly the period between the technological implosion and the Global Financial Crisis (JRC), the real return on 10-year government bonds averaged 2.04% and the median forward price earnings ( The P / E ratio for the S&P 500 index was 16.3. From 2008 until the end of 2021, the index’s P / E ratio averaged 16.8, while the 10-year real dividend was 0.39%. For growth stocks, the P / E expansion was more remarkable with an average of 17.4 before the JRC and 20.5 subsequently. For equities combined, more expansion was put in turbo as real interest rates plunged deep into negative territory following the start of the COVID-19 pandemic.
The party is pretty much over. In line with rising expectations of policy tightening, the S & P 500’s full-year 2022 P / E ratio has been compressed by approx. 9% year to date to 19.8. The multiple for the pure growth component of the S&P 500 has fallen by a more serious 19%. How much lower can multiples go? It depends on the path that the Fed ultimately takes. What is certain is that many equity segments will continue to see multiple compression as real interest rates march toward positive territory.
Just a piece of the puzzle
Shares that lose support from strong valuation multiples do not mean that it is all doom for stocks. There are other factors that affect stock performance. Implicit in lower long-term bond yields is a declining economy. Companies that can grow earnings at a pace that is higher than the economy can expand will still have a premium and thus support their multiples. There are plenty of graduates to deliver such growth. While much of the technology sector has been among the most 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 emerging markets will deserve a new look.
Other growth segments include the global push towards decarbonisation and the reconfiguration of supply chains, as large regions of the world seek to locate important industrial inputs. These examples should serve as reminders that stock valuations can become more attractive, not only through multiple compression, but also by companies proving that they can grow to elevated multiples by increasing earnings faster than the market expects.
Guest comments like this are written by writers outside of Barron’s and MarketWatch’s newsroom. They reflect the perspectives and opinions of the authors. Submit comment suggestions and other feedback to firstname.lastname@example.org.