Since it costs a lot to win
And even more to lose
You and me bound to spend some time
Wondering what to choose
“Deal” – The Grateful Dead
We have been surprised by the degree of large cap equity market strength in the first half of 2023 (we penciled in 4,200 as an upside cap on the S&P 500 for the year).
In the piece below, we revisit our thesis for the economy and markets from the beginning of 2023, identifying the divergence of equity valuations from yields/Fed policy as the key source of our surprise. We then look at the two main drivers of this yield divergence and equity strength (liquidity and AI optimism).
This analysis sets up for our Mid-Year Outlook coming next week, where we will explore if we can count on the drivers of equity upside in 1H23 to continue into 2H23.
So, in honor of Dead and Co.’s “The Final Tour” run at Citi Field this week, let’s “spend some time wondering what to choose.”
Our key thesis for the economy and markets to start 2023 went as followed:
Economic data would hold in better than expected, with a recession both less likely than consensus expected (65% Bloomberg consensus probability to start the year) and unlikely to come as early as consensus expected (a late first half/early second half recession was expected)
Inflation would continue to moderate but would remain stickier and more elevated than the Fed and markets expected, partially due to more resilient economic data.
Better growth and persistent inflation would keep the Fed “engaged” in its tightening cycle, likely to hike rates further than consensus expected (4.9% terminal rate expected to start the year) and unlikely to deliver on the pivot to rate cuts that was expected to begin early in the second half of the year.
Bond Market Implications: This better data and tighter Fed path would keep upward pressure on/put a floor under yields. Bonds would do better than 2022 but remain volatile given higher-for-longer Fed path. Credit could remain stable as long as recession risks remained contained.
Equity Market Implications: Equity returns would be muted in 2023, due to continued pressure on valuations from a tight Fed and lackluster earnings growth (not because of an imminent recession, but a normalization of margins as inflation/pricing power continued to moderate)
It is this last expectation for muted equity returns driven by a tight Fed keeping a lid on valuations where we have been the most surprised and off-base this year.
The Fed has, in fact, delivered on a tighter-and-longer-than-expected policy, resulting in upward pressure on yields, however equity valuations have not seemed to care, completely diverging from yields.
Nowhere can we see this more sharply than in the relationship with Growth valuations and real 10-year yields (real yields are nominal yields minus inflation; Growth valuations have had a strong inverse relationship with real yields since late 2018’s “Powell Pivot”, where plunging real yields ignited a surge in Growth valuations).
As can be seen in the chart below, real yields remain in a restrictive, positive territory (near +1.5%), while Growth valuations have powered back to pandemic-era territory (currently 26x forward), which during that time were supported by aggressive monetary policy easing and deeply negative/stimulative real interest rates.
We can also see this divergence with Fed rate expectations. In response to the regional banking turmoil, traders initially priced in aggressive Fed rate cuts in 2H23 (which one could argue would be good for Growth valuations). However, as the dust has settled and economic data has proven to be more resilient, the rate cut bets have been unwound. The expected Fed rate in December 2023 is up ~150 bps from the March low to 5.25%, and yet at the same time, Growth valuations have expanded nearly 20%.
Both of these divergences, from current yields and forward policy expectations, show that the Fed simply has not mattered for equity markets in 2023.
There are two ready explanations for these divergences from past relationships:
1. Liquidity: As Ben Emons detailed last week, liquidity has been providing a boost to global markets in 2023. From the Fed’s lending facilities to help regional banks, to the Treasury spending down its cash balance in the runup to the debt ceiling, to Japan continuing its ultra-easy policy of bond buying for yield curve control, to China trying to support its flagging recovery, liquidity has been a positive in 2023 (after being a key negative in 2022).
In the chart below, we show a proxy for Fed-related liquidity (Fed Balance Sheet + Bank Term Funding Program – Reverse Repurchase Balance – Treasury General Account Balance). It is clear how falling liquidity coincided with weak equities 2022, while expanding liquidity has accompanied 2023’s equity strength (all the while the Fed continues to talk hawkish and raise rates!). Liquidity is a key driver of equity valuations, so tight liquidity coincided with valuation compression in 2022 and more abundant liquidity coincided with valuation expansion in 2023.
A key question going forward is whether this liquidity boost will continue in 2H23.
We see potential for liquidity to fade as a tailwind to equities in the back half of this year (more to come on this next week). This doesn’t have to spell ruin for the equity rally, but it is a key watch for valuations.
At best, the lack of incremental liquidity could cool and slow the feverish valuation expansion that has driven markets YTD (all the S&P 500’s YTD gain has come from PE multiple expansion).
At worst, a drain of liquidity could put downward pressure on valuations (similar to 2022), which are already elevated versus history (the S&P is trading at 19.1x forward, its pre-pandemic peak).
To offset this valuation headwind, earnings growth would need to deliver to the upside. Stronger economic activity continued elevated inflation and pricing power that preserves margins, and tech-related CapEx could all be sources of earnings upside. Interestingly, these potential earnings drivers have been present in the last three months, and yet earnings have been revised slightly lower looking out into 2024 (maybe this creates a low bar like it did during 1Q23 earnings season, which surprised to the upside).
The discussion of earnings leads us to our next driver of equity/yield divergence.
2. AI Optimism: The growing optimism around artificial intelligence (AI) has provided a clear boost to U.S. large cap equity indices in 2023 given the significant weighting of AI-related stocks in these indices (such as NVDA and MSFT alone as 20% of the NASDAQ 100 and are up +190% and +40%, respectively).
Helping to explain the equity valuation divergence with yields, large weighted and high-valuation AI-related tech/communications names have driven the S&P 500’s stretched 19.1x valuation, while the “average stock”, as seen by equal weight S&P 500, is not stretched at just 15.3x.
For some AI players, the sharp move higher in their stock prices have been justified by massive earnings revisions higher (NVDA’s 2024 EPS forecast was revised higher by a stunning 68% after the most recent earnings report), but for others, even with direct exposure, the immediate earnings boost from AI has yet to be quantified (MSFT’s 2024 EPS forecast has been revised higher by just 3% since the start of 2Q23, with a 30% surge in its PE multiple being the driver of the stock’s upside, just like the rest of the market).
Of course, sell side equity analysts are notoriously slow to update estimates, mostly in the face of a potential paradigm shift in technology. This is why valuations initially surge for high-growth-potential companies, and the earnings revisions eventually follow (hopefully).
For the rest of the market/economy, the earnings benefit of AI technology is more nebulous. Some have tried to quantify what broad AI adoption could mean for S&P 500 earnings, with one of the initial takes arguing it could add 11% to S&P EPS… in 20 years!
For a more immediate impact, we think the infrastructure and CapEx investment needed to support the adoption of AI technology is of greater effect to select company earnings than the potential for broadly higher corporate margins from AI efficiency gains (which may take longer to materialize, with high uncertainty about where the efficiency benefits will accrue).
There is a clear investment boom occurring in the race to adopt AI technology. We see evidence of this investment boom in semiconductor chips (hence NVDA’s blowout earnings revisions), equipment, and manufacturing facilities (see the surge higher in U.S. manufacturing construction in the chart below, boosted by the CHIPS act). We are also seeing renewed strength in data center spending that incorporates this advanced computing technology, even benefiting industrial companies that provide electrical equipment and climate control for these facilities.
Investors will have to judge the sustainability of the investment boom in judging to what extent this strong growth is reflected in today’s stock prices.
In 2023, U.S. large cap indices have enjoyed the great fortune of having large weightings to AI-related companies. We are likely still in the early days of determining the potential impact of this exciting technology on both the economy and earnings. We could also be in the early days of AI optimism feeding on itself to blow a valuation bubble. As long-term investors we remember the phrase, “markets tend to overestimate in the short run and underestimate in the long run” as we navigate what could be a rapidly evolving technology landscape.
Conclusion: Overall, the key source of the upside surprise to our equity return expectations for 2023 has been the ability for equity markets to diverge from higher yields and tighter Fed policy. This divergence has been fueled by improved liquidity and optimism (plus real growth) related to artificial intelligence. Next week we will explore the durability of these upside drivers as we present our Mid-Year Outlook for 2023.
Top Points of the Week
By Ben Lope
1. Global equities forfeit some gains – Global equities gave back some gains from their extended run and were down on the week. Within the US this pullback was most notable in value and small cap indices, down ~2% and ~3.5%, respectively. International developed and emerging markets were both down, although developed markets edged out their international peers by ~1%.
2. Yield curve inversion increases, breaches 1% – During the shortened trading week the yield on 2 year Treasury notes increased slightly while the yield on 10 year Treasury notes decreased slightly. These slight, but divergent, moves pushed the level of yield curve inversion (measured by the spread between 2-year and 10-year Treasury yields) over 100 bps for the first time since early March. An inverted yield curve is commonly cited as a harbinger of a recession, though providing little clarity about the timing of a recession. Thus far the yield curve has been inverted for over one year, but recession forecasts continue to be pushed farther into the future.
3. Oil prices remain rangebound – Oil futures ended the week slightly lower after the Bank of England’s announcement of a higher-than-expected rate hike on Thursday (in response to hot inflation data) erased modest midweek gains and restoked global recession fears. Oil prices have remained relatively rangebound this year, supported by key technical levels on the downside, but capped by underwhelming demand on the upside, a likely byproduct of heightened interest rates and recession fears.
4. Powell’s Congressional testimony reaffirms “slow and steady” approach – Federal Reserve Chairman Jerome Powell provided testimony on monetary policy to committees in both chambers of Congress and echoed statements that he made during the Fed’s official policy meeting last week: rates will continue to move higher, but at a slower pace. The Fed’s most recent dot plot and Powell’s congressional testimony imply that two more rate hikes are likely to be enacted this year. Markets are pricing in a 75% chance that the next hike occurs at the Fed’s July 25-26 meeting.
5. Jobless claims remain elevated – Jobless claims remained elevated for the third consecutive week, as the Bureau of Labor Statistics reported 264,000 new claims for the week ended June 17th. Claims have not been this elevated since October 2021. This trend will continue to be watched as a potential sign of softness in the labor market, which, as evidenced by rising wages and a low total rate of unemployment, remains resilient.
6. Leading Economic Index continues decline – The Conference Board’s Leading Economic Index, which uses a basket of financial and economic data inputs to calculate a composite index value, declined again in May. The primary contributors to the index’s drop came from “soft data” survey readings related to consumer expectations and business conditions. Similar to the currently inverted yield curve, this indicator has long been foretelling a recession that has yet to arrive.
7. Bank of England hikes rates more than expected – The Bank of England hiked interest rates by 50bps during their policy meeting on Thursday, overshooting analyst expectations for a 25bps hike. The United Kingdom’s May inflation reading of 8.7%, the highest among wealthy countries, prompted the central bank to continue along its hawkish policy path and lift its main interest rate to 5%. The BOE began hiking rates prior to the Federal Reserve and ECB and provides a testament to not only the global nature of inflation, but its stubbornness as well.
8. Chinese central bank cuts key interest rates – The People’s Bank of China lowered two key interest rates on Tuesday as the world’s second largest economy contends with a slower than expected recovery that has caused forecasters to slash their GDP forecasts. China’s central bank is attempting to engineer stimulative measures that will spur productive economic growth while limiting speculative property investment, which has slowed but remains a looming systemic risk for the Chinese economy.
9. Other central banks – In addition to policy decisions made by the Bank of England and the People’s Bank of China, the central banks of Switzerland, Mexico, and Turkey also held policy meetings this week to determine the appropriate levels of key borrowing rates. The Swiss national bank hiked rates by a modest 25bps, the Bank of Mexico left rates unchanged, and Turkey hiked rates by a whopping 6.5%, boosting the country’s key interest rate to 15%.
10. Economic events next week – Next week’s economic calendar will reveal if key pieces of “soft” and “hard” economic data continue to paint opposing pictures of the US economy. On the “soft data” front are the releases of the Conference Board’s Consumer Confidence Index and the University of Michigan’s Consumer Sentiment Index, while the “hard data” will be borne out through releases of new home sales, finalized figures for Q1 real GDP, initial jobless claims, and personal income.
Abbreviations: AI: artificial intelligence; BOE: Bank of England; Consumer Confidence Survey: measures the level of consumer confidence in economic activity; Dot Plot: The Fed dot plot is published quarterly as a chart showing where each of the 12 members of the FOMC expect the federal funds rate to be for each of the next three years and the long term; ECB: European Central Bank; EPS: Earnings per Share; Leading Economic Index (LEI): provides an early indication of significant turning points in the business cycle and where the economy is heading in the near term; Powell: Jerome Powell, Chair of the Board of Governors of the Federal Reserve System; Real yields: nominal yields minus inflation; University of Michigan Consumer Sentiment Index: a survey of personal consumer confidence in economic activity, which is used to estimate future spending and saving.
Index Information: All returns represent total return for stated period. S&P 500 is a total return index that reflects both changes in the prices of stocks in the S&P 500 Index as well as the reinvestment of the dividend income from its underlying stocks. Dow Jones Industrial Average (DJ Industrial Average) is a price-weighted average of 30 actively traded blue-chip stocks trading New York Stock Exchange and Nasdaq. The NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on the Nasdaq Stock Market. Russell 2000 is an index that measures the performance of the small-cap segment of the U.S. equity universe. MSCI International Developed measures equity market performance of large, developed markets not including the U.S. MSCI Emerging Markets (MSCI Emerging Mkts) measures equity market performance of emerging markets. Russell 1000 Growth Index measures the performance of the large- cap growth segment of the US equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 years). The Russell 1000 Value Index measures the performance of the large cap value segment of the US equity universe. It includes those Russell 1000 companies with relatively lower price-to-book ratios, lower I/B/E/S forecast medium term (2 year) growth and lower sales per share historical growth (5 years). The BBB IG Spread is the Bloomberg Baa Corporate Index that measures the spread of BBB/Baa U.S. corporate bond yields over Treasuries. The HY OAS is the High Yield Option Adjusted Spread index measuring the spread of high yield bonds over Treasuries. Sector Returns: Sectors are based on the GICS methodology. Returns are cumulative total return for stated period, including reinvestment of dividends.
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