Market Update 4th September 2023
It has been a strange summer in a strange year. A former US president has been arrested and charged with 91 felony counts across 4 states. He self-declared his height and weight in line with Muhammed Ali in his prime. He’s a one-man crime wave, but there is an idea going round this might help him get re-elected in 2024. Say what you like about Liz Truss, but no one is hauling her in front of the beak. The top 2 films at the box office by some distance were Barbie and Oppenheimer. One is a film about a plastic doll who becomes a real girl, leaves her fairy tale world and tries to find out who she is and what it means. The other is about a real historical figure and how hard it is to know ourselves, much less anyone else.
Markets have also been full of plot twists and unexpected connections in 2023. Central banks have continued tightening, but risk assets have risen strongly as a result. This is not something you would expect and the market calls this “no landing”. They mean that since rate rises have not caused a recession yet, they might as well keep buying risk assets, and since there is no recession, the central banks keep tightening. I don’t claim to be the smartest, but don’t think there is any such thing as no landing, but I keep hearing people talk about it like it might be true.
The S&P is trading at 19x forward earnings. The earnings yield is the inverse of this, which is just over 5% – below US interest rates at 5.5% and below investment grade bond yields. Again this is unusual – it is usually higher than both, which is the risk premium for holding equity. The US equity risk premium tends to be 4%-6%. Let’s call it 5%, plus the 5.5% risk free rate would give you an earnings yield of 10.5%, which implies a p/e of 9.5x – the S&P would have to halve from here. As it is, with no risk premium at all you are dependent on earnings growth for equity returns – a clue perhaps as to why not just technology stocks, but specifically profitable tech have been the best performers this year. At the same time Goldman Sachs tell me the total number of unprofitable listed companies in the US has risen from 10% in 1960 to almost 50% in 2022, but the market is treating these companies more harshly.
The key driver behind all this is the yield curve, which has been inverted for some time – meaning rates at the short end are higher than the long end, instead of the other way around. Its effect is being felt across the whole market and a number of otherwise unrelated trades have become correlated. It is causing investment trust discounts to widen, high yield bonds have outperformed investment grade, which in turn are outperforming government bonds, a long position in high beta currency is outperforming traditional safe havens such as the Swiss franc, or Japanese yen. Risk on is very much outperforming risk off everywhere you look.
In spite of this, the market is still focused on inflation, but from 2024 onwards it flattens out – a little over 2% in Europe and the US, closer to 4% in the UK – while rates and rate expectations remain high. What does this mean? There are two possibilities. One is the market is discounting very high growth in the future, or the other is that – apologies for the jargon – the r* is too high. R* refers to a neutral or equilibrium level of interest rates. The trouble with this is that r* has been structurally coming down for decades now due to lower global growth and demographic changes. It was up around 7.5% in the 1980s but has been flat around 2.5% since the turn of the century. It would be unusual to say the least if the market suddenly decided it should be higher, which leads us back to the first possibility – but who thinks we are about to see runaway global growth?
It can’t last and it won’t. Elections are due in 2024. Something will break – we seem to forget it already has. We used to call them Silicon Valley Bank and Credit Suisse. Last week brought news that UBS earned a record $29bn profit, up from $2.6bn last year, following their $3bn rescue of Credit Suisse, which took place behind closed doors on a Sunday. Nice work if you know the Swiss regulator well enough. No landing for UBS, but the rest of us will probably get one of some kind, sooner or later.
Robert Fullerton – Senior Research Analyst
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