Modern Industrial Policy

Valuation Comeuppance

Some additional chickens came home to roost this week. The first leg of the 10% correction from the late July peak was led by cyclicals, next up was defensives and this week tech and related sectors were taken to the woodshed despite generally favorable earnings. The bear steepening trigger for the equity market valuation comeuppance stalled this week but did not stabilize. As we suspected, Treasury supply in the belly of the curve where banks typically roam, was not well received. Next week brings more earnings, employment data, and an FOMC meeting that does not include updated forecasts. Following the September hawkish hold that triggered the second leg of the nearly three month long insidious Treasury market bear steepening, the growth data did not cooperate, thereby leaving monetary policy on a collision course with a nonlinear tightening of financial conditions. The August JOLTS, September payrolls and the advanced estimate of 3Q23 GDP all had shockingly robust headlines, despite softer details. The combination of strong growth data and a growth data dependent monetary policy framework, increasingly makes it likely that our unstable equilibrium --banks, real estate, small businesses and government finance stress resulting from the shape of the Treasury curve and level of rates, will overwhelm the (so far) immunized household and large financial corporate sectors.

For most of the ‘10s the equity risk premium of equities relative to Treasuries was elevated. However, in our view equities were modestly overvalued but Treasuries were extremely overvalued, due primarily to monetary policy. With 10-year real rates above the ‘00s pre-QE median level, they appear modestly undervalued. The flaw in this logic as a basis for investment is the mean reversion process is regime-based; in other words, it can take at least one business cycle to revert. When pressed this week in client discussions and media interviews we did concede that longer duration fixed income is reasonably attractive, perhaps for the first time since the late ‘90s. That said, a year from now our base case is 10s around current levels with 2-year rates ~100bp lower. In our scenario where the Fed cuts the policy rate 1% in 2024, mortgages are likely to outperform Treasuries and equities will return to focusing on a faster productivity, nominal growth and earnings regime than the ‘10s. That said, as we will discuss in this note, the probability of the reasonably orderly risk-off, valuation comeuppance becoming disorderly before it is over, is rising.

Figure 1: This equity risk premium model integrates credit spreads to measure the risk of the equity part of the capital structure relative to debt. One important note, credit spreads were historically tight in the ‘00s. The spread is compressed, but credit spreads are far from elevated.