The world has been addicted to cheap money for years. Now we are witnessing what withdrawal looks like.
Lifting interest rates from zero has led to a historic bond crash, notes Bank of America’s strategy team, led by Michael Hartnett. This year’s losses match the worst bond declines since the aftermath of the two world wars (1949, culminating with the Marshall Plan, and 1920, coinciding with the Treaty of Versailles), as did the impact of the Great Depression (with the failure of Creditanstalt, a major European bank, in 1931).
This is the product of the close to zero interest rates, with the Federal Reserve lifting its key policy rate by a total of three percentage points in 2022, including another 0.75 points in the past week. Equally important, this has pushed real, or inflation-adjusted, rates well above zero. Measured by Treasury inflation-protected securities, the five-year real yield has risen to 1.60% from negative 1.61% a year ago, according to Bloomberg.
Dramatic bond price reversal jeopardizes the world’s busiest transactions,” BofA strategists write in a client note: the dollar, US technology stocks and private equity. The threat of a “credit event” – the polite term for a crash – also looms.
The preconditions that led to the October 1987 crash are largely in place, they add. These include a volatile geopolitical backdrop, anomalous US markets that outperform the rest of the world, and the lack of international coordination. What is missing for now is a currency crisis.
But currency volatility has risen, with the
rising to its 20-year high, creating huge tensions for other currencies. The most notable loser: the British pound as markets react violently to the UK’s plan to borrow to finance tax cuts. Japan has had to step in to support the sliding yen for the first time since 1998, even as it tries to keep its interest rates low.
For now, the bond massacre has led to a 20% plus bear market decline in major stock indices except the
Dow Jones Industrial Average,
that is a decrease of 19.6%. So far, the declines have mainly been due to lower P/E ratios; the cuts in earnings forecasts have only just begun. Goldman Sachs strategist David Kostin has shortened his year-end
target of 4300 to 3600, assuming higher prices earn a P/E multiple of 15 times the assumed $234 in S&P earnings per share in 2023 (or just below the Wall Street consensus of $240.46 from FactSet) .
But Jason De Sena Trennert, which heads Strategas Research, sees an earnings recession that could cut S&P earnings to as little as $200 by 2023. Revenue recessions are typically twice as common as economic contraction, and it could accelerate producer price increases. reflect consumer prices, he argues in a customer report. However, the estimated decline of about 10% would be much less than the median decline during a recession. And falling earnings estimates could mean the next part of the bull market is just around the corner, he concludes.
Using Goldman’s estimated 15 times P/E and Strategas’ profit forecast of $200 implies an S&P 500 target of 3000. That would be an additional haircut of 18.8% from Friday’s closing price of 3693.23, which is already 23%. below the benchmark’s closing high of 4796.56. on January 3.
Frequent readers of this space may recall that S&P 3000 also prediction of former Barron’s Round table cool Felix Zulauf. He made that prediction last December, when the large-cap benchmark hovered around 4800 at its peak. Since then, however, he has maintained radio silence and unfortunately has not released any updates.
As for BofA’s Hartnett, he suggests investors “nibble” when the S&P 500 hits 3600, “bite” at 3300 and “gap” at Zulauf’s 3000 target. Further rate hikes by the Fed could increase pressure on stocks and other risky assets. Futures markets point to gains of another 0.75 percentage point in November and 0.5 percentage point in December, to 4.25%-4.50%, according to the CME FedWatch Site. That coincides with the The Fed’s Own Year-End Forecast.
But Friday saw a major contrarian bet in the tenuous world of options on interest rate futures. Someone’s been betting that December yields won’t rise as much as expected, John Brady, general manager for global institutional sales at Chicago brokerage RJ O’Brien, said in an email. That suggests someone is bracing to break something, which usually happens when interest rates rise sharply.
Write to Randall W. Forsyth op [email protected]