I Just can’t get enough
I Just can’t get enough
The markets slip and slide when we end the dove
And I just can’t seem to get enough [policy]
With apologies to Depeche Mode
The irony of the consensus belief in a soft (or no) landing and higher-for-longer (rates) is that it has become the prevailing bias just at the point where macro conditions have started to roll over. The US economy has been remarkably resilient this year. As we have noted, this is likely a function of; 1) accumulated excess savings since 2020; 2) Fed liquidity support during the regional banking crisis; and 3) the extraordinary fiscal thrust in the first half of the year. However, the forward-looking point is that all three factors have now flipped from positive to negative for the economy and markets. A related point is that it just takes time for the transmission mechanism of policy tightening to work.
Resilience in underlying macro conditions was most evident in the labour market in the first half of the year. The US unemployment rate was 3.4% in January and April or the lowest since 1969. However, the leading indicators of labour market conditions have started to deteriorate over the past few months. Temporary hiring has slowed, jobless claims have started to trend higher, and the unemployment rate is up 0.4% from the trough. US non-farm payrolls have also been revised lower for seven consecutive months. Total job openings have also plunged over the past few months. That is a leading indicator of the labour market, the cycle and implied equity volatility (chart 1).
More recently, broad US financial conditions as measured by the Goldman Sachs index have resumed tightening (the light blue line rising in the time series below signals a tightening in financial conditions). Key components that have contributed are US dollar strength and the rise in real and nominal Treasury yields. Recall that the US is a “long rate economy.” Most debt (mortgage and corporate) is priced off the long end of the yield curve. Moreover, relative US resilience compared to emerging markets (China) and Europe has contributed to the reflexive appreciation of the US dollar and correlated tightening in global financial conditions. For markets, there is a bearish divergence between the tighter financial conditions and implied equity volatility (chart 2).
The bearish divergence is also evident in the lack of risk compensation in junk bond credit spreads and the equity risk premium. The US high yield spread is only 366 basis points (chart 3). Well below the historic average of 500 basis points and probably inconsistent with the deterioration in macro conditions and tighter lending standards (as measured by the senior loan officer survey). Our sense is that the “fair value” for high yield credit spreads is probably closer to 800-1000 basis points.
The challenge for US equity investors is the equity risk premium. The S&P500 earnings yield is now 60 basis points less than the 6-month Treasury yield (chart 4). The last time short-dated Treasury yields were higher than the earnings yield was ahead of the great financial crisis in 2008. The two key consensus beliefs supporting equities are, 1) the soft landing in growth and earnings, and 2) the peak in consumer price inflation and rates. The September FOMC on Wednesday might reinforce the latter prevailing bias. However, with the cost of labour, money, and energy higher and real final sales (domestic demand) rolling over, profit margin expectations are probably too high. Stated differently the compensation for risk in US equities is probably too narrow. The conditions that would support lower rates are probably not bullish for growth and profits.
The good news in Asia and emerging markets is that risk compensation is much greater although with downside risk to the S&P500 (global risk proxy) we remain light and tight in terms of positioning. Low implied volatility and tight credit (CDS) spreads also imply that the cost of protection (insurance) is inexpensive for the potential payoff for investors who can buy protection.