At the start of the year the consensus view was that the most aggressive rate hikes since the 1980s would push the US economy into recession in the first half of 2023, taking corporate earnings down together with the S&P 500. Yet the S&P 500 is up nearly 19% this year and the “most forecasted recession in history” is nowhere to be found, having been replaced by a “soft-landing” narrative.
Following the 25 basis-point hike by the US Federal Reserve last week, the current cycle has seen a cumulative 525 bps worth of hikes over 16 months. This really hasn’t been a long cycle when one considers that the average duration of the last 12 hiking cycles, since 1954, has been 28 months. And, of the last 12 hiking cycles, the S&P 500 has risen during 11 of them.
Through this lens, the strong market this year should not surprise anyone. What should surprise us, however, is that the strong performance this year has been driven entirely by a re-rating of equities, while earnings growth has been flat. This is surprising because the driver of performance has been flipped around. Strong performance during previous hiking cycles has typically been driven by strong earnings growth off the back of a heating economy – the very reason why rates are hiked. All while equities typically de-rate in the face of higher interest rates.
Inflation has been high this year – above the Fed’s target level – but not as high as expected. Growth has been stronger than expected. The Goldilocks combination of growth surprising on the upside and inflation surprising on the downside is what has driven the increase in valuations this year, all while rates continue to be ratcheted higher.
The resilience in the US economy has been on the back of two things: the higher fiscal stimulus we’ve seen over the last couple of years, leading to increased excess savings, and corporates locking in low interest rates before the hiking cycle commenced. This means that companies and consumers have been a lot less sensitive to higher rates in this cycle and it will take more time for the tighter monetary policy to start biting – the variable lags will be longer than normal whilst this cycle is still much shorter than usual.
The rerating in equity valuations has occurred at a time when the yield curve remains inverted, pressuring the usual providers of funding. This has resulted in a capital structure that's upside down: the yield on investment-grade corporate debt at 5.5% is higher than the earnings yield on the S&P 500 at 4.5%. It suggests that growth expectations have moved a long way since the beginning of the year – pricing in a soft-landing scenario.
The inverted capital structure means that economic incentives for the allocation of capital within companies are skewed in favour of de-leveraging. Not only will interest costs start rising for corporates; over the last decade, it routinely made sense for companies to issue debt to fund the buyback of equity, but this no longer makes sense in a world where the cost of capital has been flipped. Against this backdrop the current outlook for growth assets is challenging.
10X Investments is an authorised FSP (number 28250). The content herein is provided as general information. It is not intended as nor does it constitute financial, tax, legal, investment, or other advice.
