The divergence in consensus beliefs between the current leaders and laggards in the stock market is extraordinarily large. As several market participants have observed, the S&P500 market capitalisation index has outperformed the equal weighted index by 10% so far year to date (chart 1). Index returns have been driven by a handful of companies. The large divergence between the market cap and equal weighted index is extremely unusual and often only evident at major inflection points. A similar relative gap (~10%) was apparent in the 3-4 months prior to the market peak in the first technology bubble in March 2000. That is both interesting and alarming at the same time.
Equity market performance underneath the surface, particularly the weakness in more cyclically sensitive sectors, combined with a range of sentiment and positioning indicators is consistent with the cautious prevailing bias and the fear of recession. Despite near term resilience in the household, service sector and labour market, the best leading indicators remain consistent with a hard landing (chart 2).
Resilience in the S&P500 might reflect some optimism that the Fed will be able to drop rates following a decline in consumer price inflation. Although they have signalled that rates will need to remain higher-for-longer until core inflation is much closer to their target which remains around 2%. The December 2023 Fed Funds future remains at an implied yield near 5% (chart 3).
As excellent point made by Gerard Minack this week is that the US is a “long-rate” economy. Consequently, the last 125 basis points of Fed tightening has done very little to tighten financial conditions for the private sector. Indeed, broad financial conditions based on the Goldman Sachs Index have eased around 100 basis points since the peak in October last year (chart 4). Corporate yields and mortgage rates (not shown) have also eased over the same period. While the total cost of debt (yield) on corporate bonds is still elevated, the credit risk premium (compensation) is below average and unattractive relative to duration-free Treasury Bills. Similarly, the equity risk premium is also modest.
Counterintuitively, a “soft-landing” might be challenging for markets if it keeps inflation elevated, interest rates higher and lending standards tighter. While there might be a buffer from excess savings (and money supply) from the extraordinary stimulus following the pandemic, that might reinforce the need for further policy tightening. As we noted this week, liquidity will also likely tighten as the Treasury issues debt and rebuilds TGA reserves drawn down over recent months. The signal from the deeply inverted yield curves is that the Fed has already over-tightened. The only way to resolve that is to see a sharp reduction in rates – and that typically comes from recession.
The key challenge for equities and credit is risk compensation. The S&P500 is trading on a 5.2% earnings yield or 18.9 times 12-month forward earnings. That is at a discount to the 6-month Treasury bill or the “duration” risk free asset. Furthermore, the breadth of the current rally is extraordinarily narrow. Historically that is not a sign of market strength. Even within the NASDAQ, the cumulative advance-decline line has trended lower as the index has moved higher. That contrasts with bull-market advances in 2015, 2018 and from the 2020 low (chart 5).
The enormous gap between world equity valuation including and excluding and including US technology is also reminiscent of the episode in 1999/2000 (final chart). While equity and credit risk compensation are considerably more attractive in EM and Asia, macro risk, divergences and valuation keep our net position “light and tight.”
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