THE market narrative has been consistent in 2022: Stubbornly high inflation causing the US Federal Reserve (Fed) to hike rates aggressively, leading to a dramatic strengthening of the US dollar and a sharp climb in bond yields. The 238 basis point (bps) rise in US Treasury yields year to date (as of Sep 30) is one of the steepest and largest climbs in history, effectively erasing almost 14 years of positive return in just nine months.
This steep ascent in US Treasury yields has negatively impacted the US stock market. The S&P 500 is now down by 25 per cent, with the index falling 10 per cent in just September. The combined fall in both US equities and Treasuries is the worst since 1938.
Rising yields impact stock markets in a few ways. The equity risk premium is the additional return investors expect to receive or the premium from risk assets compared to risk-free assets such as US Treasuries. If the equity risk premium of the S&P 500 is at 3 per cent – could possibly be higher but not lower – and with the 10Y US Treasury yield at 3.8 per cent currently, the total return an investor in the S&P 500 should get is 6.8 per cent. However, with a current 12-month forward P/E of 16 times, the S&P 500’s yield is only at 6.25 per cent. The S&P 500 needs to fall to around 15 times 12-month forward P/E to yield 6.8 per cent.
Another way an incessant fall in bond prices affects equity markets negatively is via the mechanical increase in equity allocations in traditional balanced portfolios. This obliges portfolio managers to pare down their equity holdings just to maintain the equity allocation.
Given the strong negative feedback loop between bonds and equities, a sustained recovery in the equity markets is only possible if bond yields fall (or bonds prices recover).
However, indications are that bond yields will remain on the ascent as the Fed strengthens its resolve to fight inflation by hiking rates further. For a more sustained rally, we need convincing evidence that inflation is on a downward trajectory, allowing central banks to become less hawkish and perhaps pivot to a neutral or dovish monetary policy.
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With leading economic indicators slowing and markets in disarray, optimistic investors will once again start prognosticating and hoping for a dovish policy pivot, which is not only unrealistic but also erroneous as the Fed is still trying to regain its inflation fighting credibility amid an overheated labour market.
Jumbo rate hikes of 75 bps from the Fed may dent growth, but a slower pace of tightening could hurt bonds by making inflation more entrenched. It will take a few quarters for the US labour market to cool down because the issues are structural in nature and not cyclical, and even longer for core inflation to trend down to the Fed’s target of 2 per cent.
I had written in this column in both June and August that after the sharp sell-off in the first half of 2022, any market rally off the lows was not sustainable as inflation remains at record highs. The Fed was unlikely to pivot to a dovish policy and therefore there was room for yields to climb and stock markets to fall.
From July to August, a descent in 10-year US Treasury yields from 3.5 per cent to 2.8 per cent led to an 8+ per cent rebound in the S&P 500. But since then, yields have climbed back up to 3.84 per cent (30 September) and the S&P 500 has declined by 10 per cent in September, decisively breaking its June lows.
The S&P 500 has attempted three other rallies of 6 per cent or more this year, with each rally fading and followed by new market lows, as interest rates and bond yields continue to rise alongside stubbornly high inflation.
Likewise, a short-term bounce off the current levels could be possible, but unlikely sustainable, for the simple reason that the S&P 500 is barely at fair value. Currently, the index trades at 16 times 12-month forward P/E, whereas the 20-year historical average is 15 times, with the outlook for corporate earnings deteriorating as the risk of the US economy heading into a recession becomes more likely with each jumbo rate hike.
Furthermore, each of the Fed’s upsized 75 bps hike came in June, July and September, with the money markets pricing in another 125 bps hike over the remaining two policy meetings for this year. The much higher interest rates – and hence borrowing costs – will likely start impacting corporate earnings in a meaningful way from Q4 onwards. We started 2022 with the Fed’s terminal rate at 0.25 per cent and will likely end the year nearer 4.25 per cent, a jump of 400 bps.
A major problem dealing with economic shocks is that some are transitory while others reflect a structural shift in the fundamentals and underlying causes. Inflation today may not be as high as the late 1970s and early ‘80s, but it is certainly far more complex and multi-dimensional.
De-globalisation, a smaller working-age labour force, geopolitical tension – all these issues support the case for structurally higher inflation, which means investors should expect a further decline in profit margins and higher interest rates for years to come.
The writer is regional chief investment officer of UBS Global Wealth Management.
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