• After a 20% drawdown in the S&P 500, it’s worth taking a step back to examine some of the biggest drivers in the current market environment: Federal Reserve (Fed) positioning and equity fundamentals.
• Following a shift in tone from the Federal Reserve communications, investors are waking up to the old adage “Don’t Fight the Fed.”
• At the same time, equity yields have not advanced as rapidly in recent months as fixed income yields, closing the gap and implying that TINA (“There is No Alternative”) may be dead.
After a 20%+ decline in the S&P 500,1 it is worth gathering our thoughts and understanding where we stand. While the market is very complex, it is helpful to simplify the current backdrop and break things down into their key components. The best prism through which to view the current environment is by understanding the Federal Reserve’s (the Fed’s) positioning alongside basic equity fundamentals.
The Fed: This is what it sounds like when doves cry…
- “How likely is it that monetary policy can lower inflation without causing a recession? Our goal is to restore price stability while fostering another long expansion and sustaining a strong labor market. In the FOMC2 participant projections I just described, the economy achieves a soft landing, with inflation coming down and unemployment holding steady.” – Jerome Powell, 03/21/2022
- “So, there is a path to that. Now, I would say I think we have a good chance to have a soft, or a softish, landing or outcome, if you will.” – Jerome Powell, 05/04/2022
- “The question whether we can execute a soft landing or not — it may actually depend on factors that we don’t control.” – Jerome Powell, 05/12/2022
- A soft landing “is our goal. It is going to be very challenging.” – Jerome Powell, 06/22/2022
That certainly escalated quickly, and let’s not overcomplicate this – the Fed’s communications are gradually turning more negative, reminiscent of last year’s “transitory inflation.” At this point, we should believe what Powell is saying. The Fed remains the most important game in town, and if you didn’t realize this 10 years ago, now is the time to wake up: Don’t fight the Fed! We are in a tightening cycle in which the Fed is trying to reduce demand and inflation via a reverse wealth effect:
The "wealth effect" is the notion that when households become richer as a result of a rise in asset values, such as corporate stock prices or home values, they spend more and stimulate the broader economy.
– National Bureau of Economic Research
We must view every asset allocation decision through this lens and raise the level of scrutiny for each decision that challenges this concept. And make no mistake, the Fed is playing catch up. The next two charts show CPI and the 10-year Treasury rate relative to their historic means (dotted line) and +/- 2 standard deviations.
Inflation is nearly two standard deviations above its historic mean and the 10-year rate is one standard deviation below its historic mean – this is not a sustainable gap. And while inflation reaching a peak is on everyone’s mind, we should be more concerned about the persistence of inflation at high levels, as this compounding effect really erodes household wealth.
Equity Fundamentals: Say Goodbye to TINA (There Is No Alternative)
For broad valuation techniques, some people like to use Cyclically-Adjusted Price to Earnings ratios (CAPE) and some people like to use standard Price to Earnings ratios (P/E), below we get the best of both worlds by averaging them together and then inverting the number to get an earnings yield that is comparable to bond yields.
As the chart above shows, we are coming off historically low equity yields and quickly approaching the historic mean (still approximately 10% below current valuations). When we view valuations alongside company margins, we get a more detailed view of the current situation.
S&P 500 profit margins are currently two standard deviations above their historic mean. Empirical Research recently studied this margin expansion and found that lower taxes and interest rates were responsible for nearly 75% of corporate margin expansion since 20103. Interest rates are already a headwind, and going forward tax policy seems unlikely to provide a tailwind. Furthermore, we know that inflation erodes margins once consumers stop accepting price hikes. Shrinking margins can eat into the earnings side of P/E multiples and could result in price declines to maintain the same valuations. With equities yielding just below 4.5% and the much safer 2-year Treasury bonds offering 3.2% there are now other options. Goodbye TINA.
In summary, while valuation declines should inherently make us more bullish on future returns, the current environment still maintains apparent headwinds. The Federal Reserve is fighting inflation and orchestrating demand destruction by reducing asset values, and valuations and profit margins remain historically high.
Quick Hitters: Less Obvious Things to at Least Consider
- High yield bond returns have performed in line with investment grade returns this year. This is because the high yield market is lower duration and also has a larger allocation to Energy, a clear outperformer in the current environment. However, these features may be concealing problems in a lower credit quality segment, as constituents outside of Energy become more vulnerable to rolling over debt sooner at higher rates. This worry is magnified in the private debt market where credit quality is even lower, the vast majority is floating rate, and issuance has really slowed down – as private markets are priced infrequently, these issues may realize on a lag.
- Which companies sold the picks and shovels to the venture capital gold rush, financed by the extremely loose monetary policy fire hose which is now shut off? That’s a lot of metaphors, but you get it, right?
- On Crypto: when do we stop pretending that a $2 trillion+ blow up can be an isolated event?
Important Disclosures & Definitions
1 Measured by SPXT Index, source: Bloomberg, time period: 01/03/2022 - 06/16/2022
2 Federal Open Market Committee
3 Source: Empirical Research Partners LLC, as of 2021
10-Year Treasury Yield: the yield that the US government pays investors that purchase the specific security.
Consumer Price Index (CPI): a measure of the average change over time in the prices paid by urban consumers for a representative basket of consumer goods and services. One may not invest directly in an index.
Credit Quality: the risk of default, often in reference to a debt instrument.
Cyclically-Adjusted Price-to-Earnings Ratio (CAPE): a valuation metric calculated by dividing a company’s stock price by the average of the company’s earnings for the last ten years, adjusted for inflation.
Duration: a measure of the weighted average term to maturity of a bond’s expected cash flows. Duration also represents the approximate percentage change that the price of a bond would experience for a 1% change in yield. For example: the price of a bond with a duration of 5 years would change approximately 5% for a 1% change in yield. The price of a bond with a duration of 10 years would be expected to decline by approximately 10% if its yield was to rise by +1%. Bond yields tend to fluctuate in response to changes in market levels of interest rates. Generally, if interest rates rise, a bond’s yield will also rise in response; the duration of the bond will determine how much the price of the bond will change in response to the change in yield.
Earnings Yield: calculated as 1/Current P/E Ratio.
Floating Rate: as opposed to “fixed rate,” an attribute of debt instruments whereby the rate of interest moves with market interest rates.
High Yield: commonly referred to as “junk” or “junk bonds,” fixed income securities rated below investment grade (below BBB).
Investment Grade (IG): a rating that signifies that a municipal or corporate bond presents a relatively low risk of default. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's. Anything below this 'BBB' rating is considered non-investment grade.
Price/Earnings (P/E) Ratio: a valuation ratio of a company’s current share price compared to its per-share earnings.
S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. One may not invest directly in an index.
There is No Alternative (TINA): a term recently used as justification for purchasing equity securities at high valuations, referencing the sentiment that any other option is significantly less desirable.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
AAI000208 07/31/2023
