Head - NAM Investment Strategy
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The recent stock market correction has involved every sector, style, factor and region
The recent stock market correction involved every sector, style and region. Defined by its swiftness, not since 1928 has the stock market experienced a more rapid 10% decline from a prevailing all-time high. Along the way, sentiment readings by the American Association of Individual Investors (AAII) retreated to pre-tax cut levels.
The stock market’s advance became unglued when a 2.9% annualized rise in average hourly earnings in the January payroll report sparked concerns of pending inflation and a Fed under new management that may be falling behind the curve.
The Citi Private Bank Global Investment Committee (GIC) expects core inflation to inch towards 2% but notes the correlation between average hourly earnings and core inflation one year hence, using Core Personal Consumption Expenditures (PCE) - has been close to zero percent (Figure 1). What’s more, core PCE today is lower than it was a year ago, 1.5% versus 1.8%.
Figure 1: Wage growth has almost no correlation to core inflation one year later
The economy should be able to absorb a modest rise in interest rates if it happens gradually. US households currently spend just 10% of their income to handle their debt payments - one the lowest readings on record and 30% less than at the height of the housing bubble (Figure 2). In addition, homes for sale opened the year 14% more affordable than the 1989-present average, according to the National Association of Realtors (Figure 3). In addition, the new tax law reduced the maximum mortgage deduction for future buyers.
Figure 2: Household debt service payments are a low share of personal income
Figure 3: Home affordability is better than average
Turning to corporations, the Moody’s Baa corporate bond yield, at 4.50%, is within 35 basis points of its lowest reading ever, so firms have not seen a material rise in their cost of capital. Recent changes to the tax code discourage the over utilization of debt by limiting to 30% the amount of interest expense than can be deducted against income.
Testing the upper end of the yield range
A break-even comparison of nominal and inflation-protected Treasuries securities (TIPs) suggests that just 10 basis points of the 2018 10-year Treasury yield increase is owed to higher inflation expectations with the rest due to other factors. These factors include incremental Treasury supply emanating from the recent tax cuts, a higher debt ceiling, and budget talks pointing to higher deficits ahead. Reduced central bank purchases are also forcing private savers to step in and make purchases previously made by the Fed; these savers appear to be demanding higher yields than the Fed to do so.
The GIC believes the bond market is testing the upper bound of its yield range. On the heels of the recent move higher in rates, a comparison of the spread between US and German 10-year yields shows US yields as already being elevated (Figure 4). Concurrently, the 10-year Treasury yield spread over core inflation is also at the high end of the range. One last point on inflation: the level of core inflation today is actually lower than it was a year ago; 1.5% versus 1.9% based on Core PCE and 1.8% versus 2.3% based on Core CPI.
Figure 4: 10-year US Treasury yields are high relative to German 10-year yields and US core inflation
While rates have risen quite a bit this year, it is important to remember that this is starting from low levels. Nominal and real rates are currently lower than at past bull market peaks.
The recent pullback brought the S&P 500 forward price-earnings ratio to 17x which is very close to its 20-year average of 16x. Treasury securities are also less fully valued than at the start of the year. In the context of updated valuation readings, two economic risks remain for investors in 2018: First, the US is already well into a long economic recovery by historical standards. A net 9 million US jobs have been added since the last economic peak in 2007. Monetary policy is the second risk. Reduced bond purchases in Europe and a reduction in Federal Reserve bond holdings will continue to absorb savings as US fiscal policy adds to supply.