The yield on BBB credit is at the highest levels in 15 years relative to the earnings yield on the S&P500, see chart below.
Credit More Attractive Than Equities
More Demand Destruction Is Needed to Get Inflation to 2%
The stock market thinks we have the worst behind us, see chart below, which shows that earnings growth is expected to bottom this quarter and then improve quite rapidly over the coming four quarters.
This forecast will only be correct if core inflation moves quickly down towards 2%. If core inflation remains around 5%, then the Fed will have to put additional downward pressure on demand in the economy and ultimately earnings.
If core inflation remains sticky around 5%, we will likely remain longer in a period with high capital costs and low earnings growth.
Why Is the Economy Still So Strong?
Why is the economy still so strong, and why are Fed hikes not having a bigger negative effect on the economy?
There are three reasons:
1. High savings in the household sector.
2. During the pandemic, IG and HY corporates extended the maturity of their loans, making them less vulnerable to higher rates.
3. The service sector is less sensitive to interest rates and continues to experience a structural tailwind after Covid with strong demand for air travel, hotels, restaurants, etc.
The bottom line is that the weaker transmission mechanism of monetary policy will keep the costs of capital higher for longer because that is what is needed for the Fed to get inflation down from currently 5% to the Fed’s 2% inflation target.
Ownership of Japanese Equities
Foreigners own about 30% of Japanese equities outstanding, see chart below. Japanese households also hold around 30%, and Japanese pension and insurance only hold 15%.
Jobless Claims Rise
Last week we saw a notable increase in the number of individuals applying for unemployment benefits. This caused markets watchers to wonder if we’re at the point where the labor market might be starting to meaningfully weaken in the wake of the Federal Reserve’s rate hikes. That brings us to the major event this week: The FOMC meeting taking place Tuesday through Wednesday. The market is currently pricing that the Fed will not hike rates, but it’s a tough call for the central bank with inflation remaining too elevated. However, signs of a softening labor market may help bolster the case for keeping interest rate increases on hold.
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Consumer Delinquency Rates Declining
The latest data shows a modest improvement in credit card delinquency rates and auto loan delinquency rates for subprime, near prime, and prime borrowers, see chart below. This is the opposite of what would be expected with the Fed trying to tighten financial conditions.
Tighter Credit Conditions Having Gradual Negative Impact on GDP
We built a small vector autoregressive model with GDP growth, loan growth, and bank lending standards, and giving a one standard deviation shock to bank lending standards using a standard Cholesky decomposition shows that it takes six quarters before tighter credit conditions have a maximum negative impact on GDP, see chart below. In other words, the negative impact of the SVB collapse on tighter lending standards will continue to accumulate until the second half of 2024 because it takes time for banks to repair their balance sheets.
European Companies by Backing Type
In Europe, there are three times as many publicly held companies as there are PE-backed companies, see chart below.
US Companies by Backing Type
The number of publicly held companies is shrinking, and there are about three times as many PE-backed firms in the US as there are publicly held companies, see chart below.
With inflation remaining elevated, the costs of capital will also remain elevated, which will continue to put downward pressure on tech, growth, and venture capital.
M&A Activity Continues to Decline
M&A activity has declined over the past two years, and this trend will continue, driven lower by central banks increasing the costs of capital as they continue to fight inflation.
