As widely expected, the FOMC left the funds rate unchanged at 5.25% at the June meeting. However, consensus beliefs on the terminal rate (where rates peak in the cycle) increased to 5.6%. The other critical point from our perch was Powell’s emphasis that, at this stage the pace of increase matters a lot less than how long policy remains restrictive. Stated differently, what is important looking forward is the path for growth and profits.
Despite the well documented narrow breadth in the equity market rally so far year to date, the prevailing bias suggests that the trough in earnings has occurred with consensus estimates expanding again over the next two years (chart 1). That contrasts with many of the best leading indicators of the macro cycle which are consistent with a deeper contraction in growth and profits.
Put another way, consensus beliefs are consistent with a 1995-style “soft-landing” or mid-cycle slowdown, rather than a deeper contraction in corporate earnings. While that is plausible, it would be unusual in a historical context. Of course, the nature of this cycle was unusual given the extraordinary policy support coming out of the pandemic.
As we noted recently, resilience in the S&P500 might reflect some optimism that the policy rates have peaked in this cycle. As Gerard Minack also noted recently, the US is a “long rate” economy and the last 125 basis points of Fed tightening has done very little to tighten financial conditions in the private sector. Indeed, broad financial conditions based on the Goldman Sachs financial conditions index have eased by over 100 basis points since the peak in October last year.
Other measures of cross asset volatility have also compressed back toward trough (pre-crisis) levels except for fixed income volatility which remains around one standard deviation above average (chart 2).
The challenge for the optimists is that risk compensation is now non-existent relative to duration-free Treasury bills. Put differently, the yield on a money market fund is higher than earnings yield on equity and the corporate bond yield (chart 3 and chart 4). Historically, that has not been a positive signal for forward looking returns. The P/E on the S&P500 is now just under 20 times forward earnings which feels heroic after 500 basis points of policy tightening.
Switching gears to Asia, the good news as we have noted consistently is that the bear market has been considerably longer and deeper. The region in aggregate is trading much closer to trough valuation multiples and levels of risk compensation. Of course, the discount is in large a reflection of the growth pessimism related to China.
From a behavioural standpoint, we also sense genuine risk aversion to allocate capital and legitimate fear on both the cyclical and structural growth outlook. While the fear is warranted, in our experience it is often an opportunity to deploy capital. The best opportunities are when we are most uncomfortable. A related point is that the authorities in China are also clearly aware of the growth problem and have telegraphed further policy support over the coming days. Our sense is that policymakers waited for the Fed-pause before easing in order not to put additional pressure on the CNY.
While equity and credit risk compensation are considerably more attractive in EM and Asia, macro risk, divergences and valuation continue to keep our net position “light and tight.” Our sense is that there is likely to be a better opportunity to scale into Asia after the northern hemisphere summer. On an extended time, horizon, forward looking returns are extremely attractive in the region, especially in under-allocated or appreciated pockets of Southeast Asia.