March 2, 2023
At current levels, the S&P 500 (SPX) is essentially unchanged from where it stood last April when terminal rates were at ~3%. Terminal rates are now ~240bp higher, 10-year Treasury yields are ~100bp higher and US equity benchmarks are basically unchanged. The recent resiliency in equity markets is not confined to the US with the EuroStoxx 50 (SX5E) now sitting at levels from January ’22 when the ECB held its deposit rate at zero. Since then, ECB rate expectations have risen 380bp and 10-year German bund yields have increased 270bp. The disconnect between fixed income and equity market performance didn’t start last spring. In fact, equities were highly sensitive to terminal rates and bond yields all last year. Rising rates pressured equities lower from March-October, while declining rate expectations were the driving force behind the Q4 equity rally. The disconnect really began a month ago when stronger-than-expected January payroll data drove yields sharply higher, while equity markets held their ground. While the recent resiliency in equity markets skews risk/reward to the downside, it’s impressive enough to consider the upside should rates and yields decline from current levels.
If higher rates are going to create a problem for the economy and equity markets, it would first show up in credit markets. Investment grade and high yield credit spreads have risen since terminal rates began moving higher on February 3, but the increase falls short of signaling distress. It’s important to keep an eye on credit spreads in the near term as anecdotal evidence of credit stress is beginning to emerge in areas like subprime auto lenders and GNMA pools. Note that today’s upwardly revised Q4 Unit Labor cost data and large increase for ’22 as a whole was cited in nominal terms. Real (adjusted for inflation) hourly compensation last year fell -2.8%, which was the largest decline since the series began in 1948.