The Big Picture – March 6th 2023

Published Mar 6, 2023

Each week, I try find unusual perspectives that are important to our industry but might be a little less obvious or not as well covered by the media. Last week’s observation comes from one of my favorite economists, David Rosenberg, and it’s a doozy. The recent increase in Treasury yields has brought the yield on 6-month T-bills right on top of the earnings yield of the S&P 500. Now, if you had the choice of buying stocks (the riskiest part of the corporate capital structure) at the same yield you could get from owning 6-month T-bills (the least-risky sovereign debt in the world), which would you buy? The answer clearly isn’t as simple as it might seem since many investors continue saying, “We’ll take the stocks!”

Situations like this have occurred in the past; most recently in 1998/1999 before the .com bubble burst and during the 2008 financial crisis. The relationship between risky yields and risk-free yields can return to “normal” quickly when stock prices fall (increasing their earnings yield) and/or risk-free rates fall. In both ’99 and ‘08 the relationship normalized due to a combination of falling share prices and Fed easing.

What’s unique about the current situation in a historical context is that over the past 20 years, equity markets have been trained to count on a “Fed put” when stock prices fall. Another way to think about that is if the Fed will always bail-out equity markets, the earnings yield premium that equity holders should receive for holding the bottom of the capital structure effectively goes away and all assets become low-risk. This completely changes the “risk-on vs risk-off” dynamic that once saw money move out of stocks and into Treasuries in a situation like this. The distinction between risky and safe has become opaque and market forces have become weak.

As long as the labor market remains strong, there is little political risk to the Fed’s “higher for longer” policy and the Fed will have staying power. But as long as the equity markets believe the Fed will be forced to ease, share prices will remain firm. And the big picture question is, does ‘retraining’ the market mean that rates can never come down again even if the labor market softens and we enter recession? That’s an unreasonable supposition. So, over the short-term, the current atypical relationship between risky and riskless assets could last longer than usual and things could get even weirder before this is over. But my guess is that Q3 and Q4 will bring this big picture question to a head.

Have a great week and for those of you who like me, will have kids home for Spring break, enjoy every minute you can!

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