March 16, 2023
Rotation into growth from value sectors began late last week after 10-year real yields reversed from strong technical resistance at +170bp. Real yields are calculated by subtracting inflation expectations from nominal yields. Inflation expectations are derived from the TIPS market and expressed as ‘breakeven’ yields. Real yields and growth stock multiples have a strong negative correlation. Lower real yields drive multiple expansion and higher real yields drive multiple compression in growth sectors, especially in Tech. For example, software multiples reached a peak Equity Value/Sales multiple when 10-year real yields reached -120bp in August 2021. We turned cautious on growth and bullish on value sectors after 10-year real yields confirmed a bottom on September 23, 2021. The S&P 500 Value Index has outperformed the Growth Index by 22 percentage points since we made that call. Ten year real yields have declined by ~45bp over the last week to +126bp today, but a top in real yields won’t be confirmed until they drop below +109bp.
The fundamental case to favor value sectors is now compromised as forward-looking indicators point to disinflation. One of the best forward indicators is the spread between CPI and PPI. The spread between CPI and PPI peaked last summer and continues to moderate at an accelerating pace. The orders to inventory ratio from manufacturing PMI and ISM surveys is another excellent forward indicator of inflation. During Covid, the order book was strong and inventories were weak with the wide spread indicating rising inflationary pressures. We’re now seeing inventories rise faster than orders and the spread is rapidly converging. As we noted above, obtaining lower real yields requires nominal yields to fall faster than inflation expectations. Regional bank failures last week and ongoing liquidity concerns for the group should put downward pressure on both nominal yields and inflation expectations. As we mentioned yesterday, the events from last week alone will result in a collapse of bank credit creation resulting in much slower growth and lower inflation. The only question now is the pace of the Fed’s reaction function, which seems impaired by its reliance on lagging indicators. In the near term, we expect market-based inflation expectations to fall a bit faster than nominal yields, keeping real yields from confirming the rotation into growth sectors.