Markets are again excited by the idea that we are close to the end of the tightening cycle. The European Central Bank (ECB) said it was important to assess the impact of what has already been done. This time next week, if market expectations are correct, the Federal Reserve (Fed) will have raised its policy rate by 3.75% this year. That is aggressive. It is inevitable that the Fed has to pause soon. US Treasury bond yields have adjusted back to levels more consistent with medium-term nominal GDP growth and look to be fairly valued. Other asset valuation adjustments have been significant but for some equities, with earnings under pressure now, it is not clear that this is enough yet. For now though, bond bulls are again enjoying challenging the hawks.
Back to normality
A chart that I have used many times during my career is one that plots nominal GDP growth against long-term government bond yields. Up until the mid-1990s there was a reasonable fit between bond yields and the medium-term average GDP growth rate. If anything, bond yields averaged slightly below GDP growth – returns from holding government bonds should be in line with economic growth (which largely determines tax revenues), with a slight discount because government bonds are risk-free assets. Yields moved much lower than economic growth rates after the Global Financial Crisis (GFC) as central banks introduced quantitative easing (QE). Investors looking for bond yields to rise because nominal growth was strong were generally disappointed.
However, after being impacted by QE, this relationship has started to normalise. Bond yields have risen back towards the trend level of nominal growth. In the ten years ending Q1 2020 (on the eve of the COVID pandemic), the average US nominal GDP growth rate was 4.0%. The average of the constant 10-year Treasury yield was 2.3% over the same period. In the previous ten-year period ending Q1 2010, average nominal growth was also 4% and the average yield was 4.4%. Central bank policy after the GFC depressed bond yields.
Assuming there is no more QE, a return of inflation in the US to the 2%-3% range and real GDP growth of 1%-2%, a range for US Treasury yields of 3% to 5% looks reasonable. Treasury yields are 4% today. The expected nominal GDP growth forecast for 2024 from the current Bloomberg consensus is 4%. Take from that what you will but we might be back to a more “normal” level for long-term bond yields. Given where we are in the cycle, there is not a strong case for them moving much higher for now. This week has seen a bullish performance by fixed income. I suspect it continues at least until the next Federal Open Market Committee (FOMC) meeting or even the CPI print. To be sure, the short-end of the curve still looks the best from a risk-return point of view. I repeat the view that total returns for fixed income look much more promising for 2023. In fact, October is looking pretty good!
Peak hawkishness, hello
The long-term rate valuation adjustment has been driven by the various macro-economic imbalances thrusting the global economy from too-low inflation for a decade to too-high inflation in the last year. The model of independent central banks targeting inflation has been challenged by the highest inflation rates for forty years. They have had to react aggressively and, even with markets more confident about a cyclical peak in rates, it is not clear when and why the central bankers will take a pause. But markets are getting more confident that a pause is close. The European Central Bank just raised rates by 75 basis points (bps) again, but the suggestion is that subsequent rate decisions will be data driven. Inflation will be high for some months to come, we know that. The delta will be on the real data which, in the Euro Area, is deteriorating quickly. My view is that the ECB has become marginally less hawkish.
Value adjusted everywhere
There have been widespread valuation adjustments across financial markets. An interesting way of looking at performance is to plot the total return of various asset classes in 2022 against their annualised daily volatility. Not surprisingly, the parts of the market with the worst year-to-date performance have been those that have had the highest daily volatility. It’s been a wild and wealth-destroying ride for the NASDAQ, small-cap equities, Chinese assets and long-duration fixed income.
Adjustment, done?
During the “abnormal” period of QE, financial assets became overvalued relative to their historical levels. Growth equities, represented by the NASDAQ index, and long-duration fixed income were extreme examples. Only a year ago, 30-year German bunds had a yield of just above 0%; 30-year US Treasuries yielded 2.0% and 30-year UK gilts were yielding 1.0%. Today the equivalent yields are 2.1%, 4.2% and 3.7%. A year ago the NASDAQ had a forward price-earnings ratio of 35x. Today it is 22x. Given where we are in the cycle, bond yields are closer to finding a new level than growth equities.
Yields higher, multiples lower
The most expensive assets on the cusp of the monetary tightening cycle have been the ones that have underperformed the most and suffered the largest downward valuation adjustment. For long-duration fixed income, the worst might be over as central banks approach the end of the tightening cycle over the next couple of quarters and inflation rolls over. Long-term bond yields have quickly reverted to the ranges that were in place in the decade before QE.
For equities, it remains more challenging. Equity price-earnings multiples are much closer to pre-QE levels. However, the earnings season is showing us that there is still more adjustment to go in terms of fundamentals. Weak reports in the technology and communications space from the US this week don’t augur well for a new bull market in growth equities. The earnings reports from high profile companies in the US point to slower consumer and corporate spending. This is what the market has expected and at last it seems to be coming through in the earnings numbers.
Cash flow visibility
For the time being, short-duration fixed income remains an attractive place to be with further rate hikes coming even if the market is no longer pushing terminal rate expectations higher. Short-duration, floating rate assets and defensive equities like the FTSE100 and the Nikkei have had the lowest total return downturns and least daily volatility in 2022. This might continue to be the case with the higher beta equity markets sill sensitive to the earnings picture. Banks, utilities and energy stocks may continue to provide the best defensive options given there is more security of cash flow in the short-term.
Spreads still have potential upside
Cash pays higher rates today and short-term fixed income pays even higher than cash with little additional risk. Significant positive returns from longer duration bonds are unlikely until inflation starts to meaningfully decline and central banks are clearly at the peak of the rate cycle. For credit, the idea that central banks might make a policy mistake by tightening too much demands a high risk premium. Spreads are wide and overall yields are attractive in credit, but they have been wider in previous cycles (2008-09, 2011-12, 2015, 2020). The mirror of that is that borrowing costs for companies are high and that will pressure cash flows for those that do need to borrow. Credit selection is important here.
Overall, earnings growth remains positive
So far, earnings for the S&P500, in aggregate, look to be coming in at around $55 per share for the weighted aggregate Q3 season. This is down from around $57 per share in Q2 but still above the $52 per share a year ago. With about 250 companies having reported so far, both sales and earnings are in line with (lowered) expectations and it is clear that there is significant margin pressure with sales growth far outstripping net income growth.
Yet the market has taken all the news well so far. Up to October 26th, the S&P500 was up 6.2% so far this month and the NASDAQ 2.1%. The stabilisation of rates and the dollar is a balance to the generally soft news on earnings.
On to the Fed
The inflation data remain key to the market view – lower inflation and a less hawkish Fed would suggest a more limited downturn for the US economy in 2023. Not quite a soft-landing but a growth trajectory that looks better than that in Europe. In the September inflation report from the US, shelter (covering the cost of housing) was up 6.6% year-on-year. This was a key contributor to the higher-than-expected core inflation number. However, house prices are starting to fall, as do the number of mortgage applications. This will eventually feed into the consumer price inflation numbers. If inflation is already declining, the labour market is remaining relatively strong, then maybe the US does only suffer a modest slowdown in growth. Next week’s FOMC meeting is crucial. Jerome Powel began the rate hiking cycle believing a soft-landing was possible. If he were to revert to anything like that view again – and that is a big “if” of course – markets would race higher into the year-end holidays.
Gilts relieved
Finally, in the UK we have some stability after the brief but disastrous experiment with trickle-down economics. Gilts and sterling have retraced much of their post mini-budget losses. The markets have priced out 146 bps of monetary tightening relative to the peak of Bank of England peak rate expectations. Markets still expect a 75 bps hike next week, but you never know with the BoE. Discussions between the new Chancellor and the Bank over what to expect on the fiscal side and clear signs of weakening growth might just sway the Old Lady to follow in the footsteps of the Bank of Canada and slow the pace of rate hikes. The new government looks a bit like the last two incarnations, but economic policy setting appears to be on a sounder footing. The 150 bps decline in 30-year gilt yields since the peak in mid-September tells us that is exactly what the market thinks too.
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