Morning Notes — New Year Outlook

The new year outlook is fairly optimistic considering 2022 was a challenging year for investment returns as rising bond yields pressured valuation multiples across asset classes. Higher bond yields always result in lower multiples, but higher real yields have a much greater negative impact on the most richly valued assets. Real yields are calculated by subtracting inflation expectations from nominal bond yields.  The Enterprise Value of many software companies were trading >20x sales when 10-year real yields were negative. The peak in valuations occurred when 10-year real yields bottomed at -120bp back in August 2021. Ten year real yields are now +150bp and software EV/sales multiples are back below their LT average near 5x. The good news is that we expect lower nominal and lower real yields this year, but only as the result of lower earnings estimates during H1’23. So, the outlook for investment returns in 2023 will be dependent on timing the transition from slowdown to policy accommodation and eventual cyclical recovery. The other good news is that bond yields signal a change in Fed policy 1-3 months ahead of time. Ten year yields sustaining levels below 3.40% will be your first clue and we expect some multiple expansion once 10-year real yields sustain levels below +108bp and rapid expansion at levels below +62bp.  

Excess US consumer pandemic-era savings expanded to ~$2.1T early last year. Two months ago, the number had dwindled down to $1.1T and is on track to reach zero by this April given current spending trends. Last year’s inflation spike started as a supply shock, exacerbated by massive fiscal and monetary stimulus. Supply conditions are improving and the unnecessary excess stimulus is burning off. The general rule is that the Fed raises rates until Fed funds matches headline YoY inflation. Consensus is looking for another 50bp hike on February 1 and another 50bp on March 22, taking the upper bound of Fed funds to 5.5%. Consensus is also looking for headline YoY CPI to fall from +5.5% in March to 4.5% in April, taking headline inflation below the Fed funds rate.