What’s Missing From Bond Markets Ahead of the CPI

The models agree that term premia are historically low and indeed negative. CrossBorder Capital reckons the term premium is its lowest since World War II, while the the New York Fed thinks it’s slightly higher than at the height of the Covid lockdown. Either way, it’s very low. And that’s strange, as generally a fear of higher inflation (suffered by a lot of us at present) means demanding a higher term premium. You’d also expect it to be higher when the bond market is volatile, which it has been of late. So the term premium isn’t telling us what it would normally.

Instead, Mike Howell of CrossBorder summarizes the possible explanations as follows:

• There’s a big recession coming (so people are desperate for safe assets).
• There’s a shortage of collateral in the system (so people pay up for long bonds).
• There’s a lack of liquidity in the system.

Howell gives greatest weight to the last two, and suggests that regulators should be concerned about it. If there is excess demand for collateral and liquidity, that would also affect inflation-protected bonds. Inflation breakeven forecasts derived from the bond markets have been reassuringly low for most of the last two years; this might explain why, and show that breakevens aren’t sending a good signal. Beyond that, if technical factors are depressing term premiums, it could also mean that other bond market indicators of the economy cannot be trusted. Which brings us to….

The Yield Curve

My colleague Bob Burgess has a long analysis about this today that is worth reading. An inverted yield curve (in which short-term yields are higher than longer-dated bonds) is held to portend a recession. When it’s imminent, you should expect the inversion to extend along the curve, with three-month yields exceeding 10-years. On that basis, the most popular version of the curve is its most inverted since 2000, and the three-month/10-year curve is now close to inversion. So that looks terrifying:

How seriously should we take this? Again, extreme-low term premiums, for reasons that don’t seem to be tied to the economy, tend to imply that this could be a false signal. Bond yields are obeying the normal rules of supply and demand, which are usually driven by the economy — but on this occasion, maybe they aren’t sending such a clear signal. An inverted curve doesn’t cause a recession, as Burgess points out, but usually the forces that create a recession also drive an inversion. This time, maybe we can ignore the yield curve. But to quote the cliche, that does commit economic bulls to saying that it’s different this time, and those are the most dangerous words in finance.

Quantitative Tightening (Very Very Frightening)

Interest rates take up most attention, but the decisions the Federal Reserve — and other central banks — have to make about bringing their balance sheets down to size promise to be even more important. The last time the Fed attempted quantitative tightening (QT), in 2018 and 2019, it was forced to reverse course by ructions in the repo market. And QT to date has had a tiny impact on the official size of the balance sheets of both the Fed and the European Central Bank:

Quantitative easing (QE) is widely seen as the preeminent driver of markets during the post-crisis decade. Could QT have a similar impact? Howell of CrossBorder argues that it could well. What matters is the effective balance sheet, which measures how much liquidity the Fed puts into the system. Not all possible actions change liquidity, and a raft of technical factors this year have stopped the balance sheet from contracting much so far. Once it does start to contract, however, it can be expected to have a non-linear effect on stock markets. Since the first Covid shutdown, stocks have tended to rise and fall with liquidity injections by the Fed. As this chart from CrossBorder shows, if the balance sheet is to shrink back to pre-Covid levels, the stock market could be vulnerable to fall much farther:

Liability-matching

One powerful downward force on yields comes from the need for defined benefit pension funds to guarantee their liabilities — the pensions they have promised to their members. Higher bond yields make it cheaper to buy the annuities that back pensions, and so when yields rise high enough to allow managers to match their liabilities, they have a big incentive to buy bonds and lock in those yields while they can. That is certainly part of the reason for the heavy demand for bonds in the last few months, and at least in part explains why bond yields have fallen since June.

As this chart from the consulting actuaries at Mercer show, the rise in yields of the last year has allowed corporate pension funds to eliminate their deficits (meaning their assets are now worth more than their liabilities) for the first time since the crash of 2008. If bond yields are at a level that allows them to guarantee that their status stays that way, they can be expected to buy more bonds:

It’s possible to lump liability-matching regulations as part of “financial repression” — measures by the government to force investors to lend to the state at uneconomically low interest rates. But a looming pension crisis has been one of the greatest fears of the last decade. If it can be averted, that would be one of the few genuinely positive financial developments of the last few months. But, yet again, liability-matching implies that the signals from the bond market don’t mean all that they usually mean.

Inflation

By the time you read this, the July US inflation data should almost be here. To make sure some important second-tier data on prices and the labor market don’t get forgotten in the rush, let me point out that unit labor cost data for the second quarter show the fastest year-on-year rise since 1982. Higher wage pressure and a problem maintaining productivity will do that. That suggests that risks of a wage-price spiral remain intact.

It also suggests that price/earnings multiples for stocks are at present way over-optimistic. Over time, growth in unit labor costs and earnings multiples (shown inverted on the chart below) have had a strong inverse relationship — if labor costs are rising fast, all else equal, you should expect multiples to drop:

Why isn’t the market re-rating stocks this way? The concern about labor costs is primarily about profit margins. If companies can pass those costs on to customers in higher prices, and maintain those margins, then there’s less need to cut their valuation. And one of the most important points to emerge from the second-quarter earnings season is that companies do indeed have pricing power. They’re worried about their margins, as they should be, but so far they’re managing to maintain them. This was a pleasant surprise for analysts; revenues exceeded expectations by 2%, but profits beat forecasts by 5%.

Goldman Sachs Group Inc.’s David Kostin has published his quarterly “Beige Book” on the main points to emerge from executives’ earnings calls. Margins and pricing power were on the list. This was his summary:

Profit margins remained a top priority for company managements in 2Q. On last quarter’s earnings calls, firms highlighted rising input costs as one of the largest headwinds to their earnings. 2Q earnings calls have revealed that input costs remain a key issue for managements, particularly as economic growth has started to slow and focus has once again turned to margin stability over sales and earnings growth. In order to offset the impact of input cost pressures, firms continue to leverage pricing power. Companies have noted that consumer demand has remained robust in the face of price increases implemented over 2Q. Some companies plan on taking even further pricing action as higher commodity prices have placed further strain on margins.

All of this is great news if you’re a shareholder, and not so good if you’re a consumer or central banker hoping for lower inflation.

Finally, the National Federation of Independent Business published its latest monthly survey of smaller businesses. The bad news is that the number complaining of rising prices and difficulty recruiting people remains near all-time highs. The good news is that these have at least been reduced from even more extreme levels earlier this year:

These are not numbers to suggest that the inflation problem is going away. They do at least suggest that the economy is now moving in the right direction. Now for some Wednesday morning excitement (or afternoon if you’re in Europe, or a nightcap for those in Asia).

The Only Way Is Tech

If you’re looking for a culprit for stock markets’ volatility in recent years, perhaps blame tech stocks. The sector has an unparalleled impact on the overall performance of US equities. If nearly 100 years of history are any guide, the S&P 500 only outperforms when the tech sector does so as well. The line graph by the Leuthold Group below shows the relative total return back to 1926 for the the sector:

The letters, as seen above, highlight major periods when the sector outperformed and underperformed. The chart below shows six significant periods of when tech outperformance pulled the benchmark index higher. Of these leadership cycles, only the period between December 1964 to November 1967 (G) saw the S&P 500 make an annualized price gain in modest single digits. The rest saw hefty double-digit gains of up to 36%:

In contrast, when tech lagged, the benchmark index saw two annualized price declines, and two with gains of less than 2%. The only stronger performance than this came in the years before 1992. For nearly three decades, then, tech outperformance has behaved almost as a prerequisite for market outperformance:

To view the relationship differently, this is how the tech sector of the S&P 500 has performed relative to the rest of the index, mapped against the performance of the S&P itself. The tendency to rise and fall with tech is evident:

At present, the S&P 500 is down 13.6% year-to-date with 151 trading days gone. Tech stocks, represented by the tech-heavy Nasdaq 100, are still lower by 20.2% for the year, while the S&P 500 tech sector is down 17.3%.

But what do tech stocks have that others do not? The Leuthold Group laid out how each sector performed compared to the stock market. It found that for all months in which tech shares outperformed, the average annualized price return of the benchmark index was 27.2%, compared to -9.3% for all months when it lagged. The entire sector functions like a highly leveraged version of the overall stock market:

Other sectors such as durables, manufacturing and financials did display similar directional effects, but not on the same magnitude as tech. Here’s Jim Paulsen, chief investment strategist at the Leuthold Group:

“For nearly 100 years, the tech sector has had a domineering influence on the stock market versus any other segment, both in terms of satisfying/disappointing performance and the frequency of losses... the relationship between tech performance and the broad stock market has been fairly persistent. Over rolling 240-month periods since 1926, when tech was in the lead, the S&P 500’s annualized return was typically near 20% or higher, and it was negative almost every time tech was trailing.”

This is why Paulsen says it’s not surprising that the performance of high-beta tech strongly correlates with broad stock market results, while sectors commonly considered market barometers, like energy, have not been useful gauges. Put differently, tech has led the economy for decades, and its success has been critical in allowing other sectors to raise their profits. Hence the entire stock market begins to look like one big play on technology.

Ann Miletti, head of active equity at Allspring Global Investments, put it this way:

“If you look at margin improvement across the indices, it’s improved because technology has played a bigger part in the indices as well. And so, it’s that innovation, it’s the leadership, it’s the better business models for the most part that technology has... As we look toward the future — we probably have no better proof of this story than during Covid — technology is improving all companies across all industries. So, if you think about the digitalization of our future, it’s happening on the consumer end, it’s happening on the industrial side, the companies that invested in that prior to Covid did extremely, extremely well.”

In the last few days, tech stocks have been under duress as investors turn more cautious ahead of the next wave of macro data, headlined by Wednesday’s CPI release. The big question now to Paulsen is: Has the tech rally peaked?

“A reasonable argument could be made that last year’s tech rollover may have marked the top of another major leadership cycle. However, our guess is the economic recovery is in a mid-cycle pause rather than an imminent recession. If that is true, the underperformance of tech stocks may already be ending. The valuation of the technology sector is far more attractive today than at the end of the dot-com cycle.”

That of course isn’t difficult; the tech sector traded at a trailing earnings multiple of 80, and nobody thinks that should be repeated. Its slide from 35 at the beginning of this year to its current level of 27 (even after its rebound) does suggest that it’s more buyable, however. Paulsen suggests that we should be due more tech outperformance — and by this logic, even with weak growth, that would imply that the broader stock market should grow too. Let’s hope he’s right.

— Isabelle Lee

Survival Tips

Lamont Dozier, part of the legendary Holland-Dozier-Holland songwriting team that penned most of the Motown songs you’ve ever heard, has passed. His oeuvre included Heat Wave (originally by Martha Reeves and the Vandellas), Where Did Our Love Go by the Supremes (and later Soft Cell), Reach Out I’ll Be There by The Four Tops, “You Keep Me Hangin’ On” by Vanilla Fudge, and later the Supremes and Kim Wilde, “How Sweet It Is To Be Loved By You” by Marvin Gaye and later James Taylor, “Give Me Just A Little More Time” by the Chairmen of the Board and later Kylie Minogue, There’s A Ghost In My House, later covered by The Fall, Stop! In the Name of Love by the Supremes, and “You Can’t Hurry Love” which has been covered by everyone from the Dixie Chicks to Phil Collins, although the Supremes still reign supreme. OK, some of them are a bit similar to each other, but what a great formula.

Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

Read more articles by John Authers