Market Mispricing: A Tale of Two Markets

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HOW EQUITIES VS RATES MARKETS TELL DIVERGENT STORIES

If there is one word to describe market sentiment this year, it is confusion. The S&P 500 rallied 9.3% in January before retracing its steps back where it started. It is now 0.98% above what it was on the 1st of January.  Major banks are divided in their market outlook in 2023, most falling into either the soft-landing or the hard-landing camps. In this publication, I will examine the divergent stories told by the equities and rates markets to argue that the market is just as confused right now as it ever was.

The key source of confusion is the change in the global monetary regime since 2021. The US market has not seen a stagflationary environment since the 1980s. Due to the significant changes in the monetary landscape and the lack of historical precedents, the market requires sufficient time to adapt to the new conditions and accurately value assets. 

Stock Market: Going for A Soft Landing

The S&P 500 currently trades at 21.12 P/E. It is slightly below its average of 25.73 since 2001, but above 16.5, the average since 1900. On a dollar basis, Bloomberg’s 2022, 2023 and 2024 consensus earnings per share estimates for the S&P 500 Index stood at $222.4, $220.5 and $245.4, respectively, as of 3/3/23. The estimated decline in S&P 500 earnings in 2023 Q1 is -6.1%.

Exhibit 1: S&P 500 P/E Ratio Since 1900 and 2001



At this P/E ratio, the equity market is pricing in a mild slowdown in the next few quarters, but an eventual pickup in earnings next year. The price does not factor in a significant decline in earnings going forward. This is the story told by the equity markets, let us turn to the rate markets.

Rates Market: Impending Economic Crash

Exhibit 2: US Treasury Yield Curve at 10/03/2023

 Fed would only ease rates if it sees a significant slowdown in inflation and/or a significant economic crash that brings inflation down, otherwise, it will be happy to keep rates “higher for longer”. However, looking at the US treasury yield curve we see that the rates market is pricing in an easing of rates early next year, as 1-year yields are lower than 6-month yields. 

This implies that the market is pricing in an impending economic crash, as it is the only way to reach 2% inflation. To get 2% inflation you need a deceleration of wage growth. To reduce wage inflation, nominal spending and income growth need to slow, and unemployment rates need to rise. For the unemployment rate to rise, corporate margins must be squeezed significantly, requiring more than a 6% decline. 

Conclusion
On the one hand, equity markets are pricing in a soft landing, on the other hand, rates markets are discounting an economic recession. Either the equities market is due for a downward correction or the yields on medium-term bonds are set to move higher. Both stories are possible, but the way the two markets are priced cannot coexist in the long term.

I do not think inflation can come down quickly, and corporate earnings could turn out lower than expected. The recently released February labour statistics have remained strong, with non-farm payrolls exceeding the consensus estimate. I do not see the easing of rates without a deeper recession; therefore, I think a deeper recession later in the year or early next year is highly possible.





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