The market looks still too complacent on equities and bonds
A deep dive into the latest market dynamics and some metric
Fed made clear that they will keep fighting inflation raising interest rates. Both the bond market and the stock market have been shocked by the hawkishness of the message as bond yields spiked and the S&P plunged around 3.5%.
It is interesting to deep dive into the Price/Earnings ratio, that according to few analyst, is currently too high.
The Price/Earnings ratio is a function of two inputs: 10 year U.S. Treasury yields (the cost of capital component) and the Equity Risk Premium (a function of growth expectations, negatively correlated to growth).
For Morgan Stanley’s analyst Mike Wilson, in fact, the largest risk is represented by earnings, not rates.
“Even after Friday's sharp decline in stocks, the S&P 500 Equity Risk Premium remains more than 100 basis points lower than what our model suggests. In short, the S&P 500 price earnings ratio is 17.1x, it's 15% too high in our view.”
While the Fed was to blame for “almost all of the weakness” in the first half of the year, Wilson reiterates that the second half of 2022 will be marked by earnings expectations. We are entering the seasonally weakest time of the year for earning revisions, and inflation further eats into margins and demand. They said:
“Our analysis of second quarter earnings showed clear deterioration in profitability, a trend we believe is just starting. In short, we believe earnings forecast for next year remains significantly too high.
We do think Friday's action could be the beginning of an adjustment period to growth expectations. That's good. In our experience, such adjustments to earnings always take longer than they should.”
Morgan Stanley’s leading earnings model sees “a steep fall in EPS growth over the next several months.”
The combination of weaker company performances with the hawkish monetary policy is also going to hit the leveraged loans section of the credit market (the lower rated loan market).
Srikanth Sankaran, a Morgan Stanley analyst, and his team warned that leveraged loans could be the “canary in the credit coal mine”: as the U.S. economy slows, cash flows will deteriorate while debt-service costs will be rising.
He wrote in a note:
"At US$ 1.4 trillion in outstanding volume, the loan market has nearly doubled in size since 2015, with a significant deterioration in quality.
Historically, the loan index has breached 750bps in spread and an 85 cash price only in the depths of the GFC and Covid. This time around, we expect these levels to be tested even in a mild recession, signaling significant downside from current levels (480bps in spread; 95 cash price).
Given current valuations, we maintain a cautious stance across corporate credit - staying up in quality and up in seniority."
A team of analysts from the Wells Fargo Investment Institute said in a Tuesday research note that investors should approach leveraged loans with caution. However, they added that a blowup isn’t a foregone conclusion, and Wells is maintaining a “neutral” outlook on the space.
One reason is that only 9% of outstanding leverage loans will come due between now and the end of next year, not a steep maturity wall.
The High Yield market is also reflecting this deteriorated sentiment, as US junk bonds hit 1,000bps psychological spread level. The premium on one of the riskiest tiers of corporate debt is once again flashing a warning sign for credit markets. The spread on CCC rated bonds moved over the 1,000bps threshold on Monday to a level that is typically associated with stress.
Priya Misra, a TD Securities strategist, is concerned markets are too complacent about rates. Spreads could widen, especially for companies with weaker credit metrics and lower ratings:
“I don’t think that default risk premium has been priced accurately in the credit space. I am concerned that the markets have become too complacent about interest rates, not quite appreciating that there’s true credit risk.”
Yield premiums on US speculative-grade corporate bonds are on track to widen for a third consecutive week following Fed Chair Jerome Powell’s hawkish remarks at Jackson Hole, but remain more than a full percentage point below their year-to-date high in July, Bloomberg-compiled data show.
They are also less than half the level of early 2020, when the onset of the Covid-19 pandemic roiled markets.
TD Securities is not alone in voicing the concern:
UBS Group AG advised investors to remain cautious on credit as the current spread levels imply a 25% chance of a recession, compared with UBS’ forecast of a 55% chance.
Strategists led by Matthew Mish wrote they expect corporate credit spreads in the US to retest this year’s wide levels “on further Fed hikes and slowing growth.”