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Reality Check in the US Capital Markets

US Capital markets

21 Apr Reality Check in the US Capital Markets

Posted at 09:11h in Blog by

US treasury yields have risen significantly since the beginning of 2024, and the bond prices fell across the yield curve. For instance, yields on two-year notes rose 0.64%, while the yields on ten-year bonds rose 0.67% during the corresponding period. This bond market sell-off was mostly prompted by the realization that the sharp interest rate increases by the US Federal Reserve since the spring of 2022 failed to slow down the economy significantly, and the labor market demand remained unabated.

Reality Check in the US Capital Markets
Bond traders were betting that the sharply inverted yield curves induced by the Fed’s interest rate increases in 2022 would invariably lead to a sharp recession in 2023 and a monetary policy pivot to interest rate cuts shortly thereafter. This so-called hard landing in the US economy failed to materialize, primarily due to relentless deficit spending by the Biden Administration since coming to the office, ostensibly to battle the impact of the (Covid) pandemic. The US Bureau of Labor Statistics announced that the US GDP rose 2.5% in 2023 compared with 1.9% in 2022 – despite the Fed’s interest increases.
Although the Fed has been indicating potential interest rate cuts in 2024 in recent board meetings, Chairman Powell consistently warned the financial markets that such cuts would be primarily data-dependent. Recent inflation data (excluding volatile food and energy costs) indicated an uptick since the bigging of the year, while non-farm payroll numbers remained robust and unemployment rates remained unchanged. This strength in the US economy is now leading to reassessing the Fed’s monetary policy and potentially postponing any cuts until 2025.
Higher short-term interest rates until 2025 and a lack of progress on the inflation front led to sharp sell-offs in bond and stock markets over the past three weeks. Technology stock valuations are highly sensitive to yields on long bonds as these rates are used to discount the future earnings of these companies. Thus, there is a rout in technology stocks – particularly in the chip sector sporting lofty valuations driven by the artificial intelligence euphoria.
Although stock market volatility might continue until summer, corporate earnings are expected to grow in 2024, aided by robust consumer spending moderating inflation from a longer-term perspective. For instance, large-cap stocks, represented by the S&P 500, currently trade at a price/earnings multiple of 19.9 compared to five and ten-year averages of 19.1 and 17.8 (Source: FactSet), which is reasonable considering the current low inflation and interest rate environment.

Thus, I am sanguine about the equity market outlook for the rest of the year and suggest steadily accumulating high-quality and profitable companies (such as the S&P 500 index) on a dollar-cost-averaging basis. Bonds are likely to face headwinds for the rest of the year, and thus, I recommend maintaining a short-term duration (two years or less) in the fixed-income portion of the asset allocation. The US dollar is likely to remain robust compared to its major trading partner currencies primarily due to real interest rate and economic growth differential (Interest rate parity theorem).