As we often note, it is important to ask: what is your quarrel with price? While markets are not efficient, it is a heroic assumption to say that they are collectively “wrong”. However, what you might suggest is that investors are complacent given some of the information we know about the probable path of interest rates, the dollar, and the deterioration in historically reliable leading indicators of future macro conditions. Put another way, risk compensation in credit (and the equity risk premium) is modest if there is a harder landing in growth and profits in the future.
Current macro conditions, especially the resilient labour market and retail spending are (for now) consistent with robust growth and not recession. The other positive catalysts, which helped to drive risk assets since the start of the year were: the peak in consumer prices, bond yields, depreciation in the US dollar and China re-opening. Of course, a key observation we made this week (in the “big flip”) was that resilient macro conditions in the near term increase the probability that the Fed eventually hike rates to a genuinely restrictive level. From our perch, that might be why the yield curve is so deeply negative (chart 1). Historically it has been perilous to ignore the signal from the yield curve. Put another way, the probability of a soft landing is very low.
As we have also noted recently, monetary policy works with long and variable lags (around 12-18 months). It will probably take some time for the policy tightening to impact growth and profits. The change in broad financial conditions over the past year will probably lead to a material deceleration in nominal GDP and profits over the next few quarters (chart 2). Moreover, near term resilience will likely contribute to a higher peak in policy rates and potentially to another reflexive phase of US dollar strength. Our sense is that might have commenced over the past three weeks which has started to challenge the prevailing bias (peak rates, dollar weakness, EM outperformance).
In that context, the equity risk premium (especially the difference between 6 month yields and the earnings yield) is very narrow. To be fair, equities have some potential inflation compensation. Furthermore, the credit risk premium, especially in sub-investment grade credit is very modest given the signal from the yield curve and other reliable leading indicators. The cost of protection (volatility) in credit is lower than it is in equities and given the volatility in rates. Corporate bonds repay debt out of cash flow, which deteriorates in a recession leading to a rise in default rates and a self-reinforcing rise in the credit risk premium. In a hard landing, junk bond credit spreads could widen to at least 1000 basis points from 440 currently.
Nothing is inevitable, especially in economics and financial markets. However, our big picture point is that the excess return on risk assets (equities and credit) is modest relative to safe assets. Stated differently, we can see smoke on the investment horizon, but the premium cost of fire insurance is still inexpensive relative to history. At the very least, investors should continue to avoid profitless companies with highly levered balance sheets.