U.S. Bond Yield Decline and Equity Recovery
The U.S. equity market rally in July has been helped by the decline in 10yr yields, which has eased the pressure on valuations and allowed a small rise in the 12mth forward P/E ratio (Figure 1). What happens next for the U.S. equity market?
Bottom line: We are reluctant to chase the U.S. equity market higher in the next 1-2 months. A soften in the Fed communications from the June FOMC stance will likely not be clear until nearer to the September 21 FOMC meeting. In the meantime, we feel that though the real sector data will worsen, long-dated U.S. bond yields are unlikely to fall much further for current levels due to the stickiness of inflation. This will leave U.S. equities having to face slower earnings into 2023 and can put the market back on the defensive over the next month and modest losses are likely.
Figure 1: S&P500 12mth Forward Earnings Yield and U.S. 10yr Government Bond Yield (Inverted) (%)
Source: Datastream, Continuum Economics
Lower Bond Yields and Higher U.S. Equities
The clear rebound in U.S. equities has some participants questioning whether a bottom has been reached and a Fed pivot can help to start a bull phase for the market into 2023. We have been bullish for 2023 (see June Outlook) and see the S&P500 to 4,300 by end-2023, but the next couple of months will likely be difficult for the U.S. equity market.
- Hopes of avoiding recession unlikely: In theory the U.S. market could build on gains, if a U.S. recession is avoided. Our view remains that real sector data is showing a slowing trend in consumption, both due to negative real wages and as post-COVID pent-up demand is largely satisfied. The breakdown of the Q2 GDP (here) shows that housing investment is entering a multi-quarter contraction phase (surging mortgage rates) and business investment is weak. Meanwhile, fiscal policy is contractionary, with the IMF cyclically adjusted deficit for the U.S. projected to decline to 5.1% in 2022 from 8.0% in 2021. Elsewhere, net exports face a difficult H2, with the lagged effects of the strong USD coming through at the same time that Europe is seeing a clear move toward recession also. We remain of the view that the U.S. will see a mild recession, which will still mean that 2023 S&P500 corporate earnings need to fall to zero or negative vs. the current expectations of +8%.
- Inflation stickiness before slowdown: The good news is that headline U.S. CPI inflation should decline y/y in July, helped by lower gasoline prices, but the market consensus is for a 0.5% core CPI inflation number. As we have highlighted, owners' equivalent rent tends to be sticky and is unlikely to slow dramatically in the next few months. This could leave inflation y/y coming down, but not enough for monthly numbers to be consistent with the Fed's inflation objective. While the Fed communications will place emphasis on PCE inflation being more important than CPI inflation (as has Fed Chair Jerome Powell), FOMC decisions will start to be impacted by core and headline CPI and the wage inflation trajectory, and these could be more elevated than PCE inflation. The labor market will soften, but the impact of wages will come with a lag.
- No Fed pivot yet: This all leaves the Fed in a tricky situation, but we feel that the Fed is sufficiently determined to get inflation down that it will not dramatically soften communications and will not eschew a hike in the September FOMC meeting. We feel that the data will eventually shift the Fed consensus to a 50bp hike in September and then a final 25bp hike in November. The Fed pivot to end tightening and ease in 2023 is unlikely to be clear over the next two months, as Fed officials will be reluctant to swing to the dovish side. Fed communications could soften in the autumn, but this is unlikely to help equities during the remainder of the summer.
- Drop in bond yields unlikely to be repeated: The decline in 10yr government bond yields has exceeded the decline we were forecasting by end-2022, as weak economic data has encouraged a swing toward fixed-income markets. This is unlikely to be repeated in August and the first half of September, as the Fed are slow to shift to a dovish tack over the summer and will remain watchful for the breakdown of inflation figures over the next two months. U.S. high-yield spreads (Figure 2) also have more limited scope to tighten against a backdrop of worsening real sector data and deterioration in company finances.
Figure 2: U.S. High Yield Spread vs. 10yr Treasuries (%)
Source: Continuum Economics (positive is USD appreciation and negative is USD depreciation).
Overall, we are reluctant to chase the U.S. equity market higher in the next 1-2 months. A softening in Fed communications from the June FOMC stance will likely not be clear until nearer to the Sept. 21 FOMC meeting. In the meantime, we feel that though the real sector data will worsen, long-dated U.S. bond yields are unlikely to fall much further from current levels due to the stickiness of inflation. This will leave U.S. equities having to face slower earnings into 2023 and can put the market back on the defensive over the next month, with modest losses likely.
Will we see fresh lows for the U.S. equity market? This is a more difficult question. The odds of the alternative view of an aggressive Fed (4% Fed Funds rate) has come down, both due to the data and as the June FOMC meeting makes clear that the Fed is becoming more data-dependent. This reduces the deeper recession risk caused by too much tightening from the Fed and reduces downside risks for the equity market. It may well be that the U.S. equity market has a further leg down that does not see new lows, despite our U.S. recession call. Renewed gains in U.S. equities will require the Fed to go on hold or the market to feel that this could be the case. Speculation on this could become rife at the Sept. 21 FOMC meeting, both due to some forward guidance for November from Powell and if the median dots for the Fed Funds rate were to decline. Even then it may not be enough to spark a sustained rally until the economy starts improving sustainably and/or we get close to the Fed cutting rates in 2023. That is why we have looked for a 10%-plus rally in 2023.