Strategists coined the term TINA (There Is No Alternative) for describing equities as an asset class during the low-interest rate era. Now that rates have risen, there is a new acronym, TARA (There Are Reasonable Alternatives). Today, U.S. faces a TARA challenge from elevated Treasury yields.
The forward P/E ratio of the S&P 500 had been tracking the inverse of the 30-year Treasury yield in the last 10 years until early 2023 when they diverged. The forward P/E and Treasury yields rose together, which made bonds more attractive. That’s the TARA valuation threat to U.S. equities.
On top of that, there’s another emerging TARA valuation threat – and it’s coming from Japan.
So long, YCC
The source of the threat isn’t primarily from Japanese equities, but a change in policy at the Bank of Japan (BOJ). For years and years, the BOJ had kept rates artificially low in order to boost the Japanese economy. More recently, the BOJ was the only major central bank to maintain a dovish monetary policy when other central banks were raising rates. This ultra=stimulative policy encouraged Japanese savers to invest their funds abroad. As a consequence, Japan had long been a net supplier of liquidity to the rest of the world.
When BOJ governor Kuroda retired and Ueda took the reins at the BOJ, policy began to shift. The BOJ had a policy in place of capping the 10-year JGB yield at 0.50%, known as yield curve control (YCC). It recently signaled that it was prepared to be more flexible on YCC and expand the allowable range up to 1.0%. The JGB yield spiked in response to the announcement, but fell back when the BOJ intervened to slow its rise. Nevertheless, the psychological damage was done and the yield rose above the 0.5% mark. Global bond markets were briefly rattled by the change in BOJ policy, as the threat of a liquidity withdrawal could be unsettling to yields. (For the same of completeness, the bottom panel of the chart shows the relative performance of MSCI Japan on a currency hedged and unhedged basis, which shows that Japanese stocks may be gaining momentum on a currency hedged basis.)
The BOJ’s YCC policy tweak has reverberated around the world and pushed up yields. While the upward pressure can be observed in the nominal 10-year Treasury yield, what’s more damaging is the effects on the 5×5 year forward expected inflation rate, which rose to a new cycle high. This increase has made the Fed’s job more difficult in the face of an apparent upward pressure in inflationary expectations.
The recent Fitch downgrade of U.S. Treasury’s credit rating also didn’t help matters. Both the BOJ’s actions and the Fitch downgrade have put upward pressure on Treasury yields, all else being equal. In addition, the U.S. fiscal position is deteriorating.
While the increases in the absolute level of outstanding debt appears alarming, net interest expense normalized as a percentage of revenues and GDP are less alarming, but nevertheless concerning. The non-partisan Congressional Budget Office estimates that net interest expense will consume over 20% of government revenues by 2033.
The fallout for equity investors is upward pressure on long rates, and the TARA valuation threat. Tactically, last week’s boost to Treasury issuance also put a damper on Treasury bond sentiment, which creates headwinds for equity risk appetite.
Disinflation a mitigating factor
The major mitigating factor to the bear case is falling inflation. Both headline and core CPI prints have been soft, both on an absolute basis and relative to expectations. Even though the downward trend is constructive, the readings aren’t at the Fed’s 2% target just yet.
Moreover, researchers at the San Francisco Fed published a
paper which argues that shelter inflation, which is a significant part of CPI, is rapidly decelerating and will slide into deflation by mid 2024.
Keep an eye on the difference between CPI, a proxy for selling prices, and PPI, a proxy for inputs. The current positive gap translates to better operating margins for manufacturers, all else being equal. This represents a silver lining for equity investors in the current disinflationary environment.
The one risk to the moderating inflation picture is energy prices. The tailwinds from falling energy prices are gone. The July CPI report showed a monthly increase of 0.3% in energy commodities, 0.2% rise in gasoline, and an astounding 3.0% surge in fuel oil.
If oil prices start to rise again, the Fed could shift its focus from a decelerating core rate back to a re-accelerating headline CPI.
In conclusion, Japan has long been a supplier of liquidity to the global financial system. The BOJ’s tweak to its YCC policy poses a threat to that paradigm and has the potential to significantly push up global bond yields. Such a change would also threaten equity risk appetite. So far, any damage from the shift in BOJ policy has been minor, but investors should monitor the effects of this policy shift as a source of risk.
Oil is way up. It affects the cost of everything being made. If the price is making a new level then we will have more inflation.
From what I have read, CAPEX is down so where will new oil come from? With what has gone on in the world perhaps the Saudis and Russians will stick to their quota reductions.
If because of the change in Japan there is some selling of US debt, this also as you point out put some upward pressure on rates.
The market may keep going up of course. Things won’t matter, until they do.
I’ve been making the bull case for oil & gas for quite a while. A lack of capex and rising demand in the medium term, but a global transition to green energy in the longer term.
Energy is the new tobacco.
Transition to greener energy will take a long time with multiple setbacks. One remembers the devastating effects when winds stopped. China is producing more coal now than a decade ago. The total life cycle energy savings of EV’s are marginally better than fossil fuels.
One can quit or reduce tobacco use. Without energy, nothing happens.
You haven’t experienced my wife quitting tobacco!
It’s why I am long uranium, best green energy for the buck, still hated/feared by many.
Oil will be around for a long time, but in a recession oil goes down (usually), so I am biding my time on that.
I think the problem is that the bearish arguments were so convincing that too many got on the bearish trade and now they pay the price.
I have been seeing an organized revolt against gov ESG policy, especially regarding EVs. The recent car-carrying ship catching fire in the North Sea off Dutch coast has generated an amount of backlash really really surprising. The fire cannot be put out so the ship is abandoned but one crew member already dead and 22 injured. First the media was still trying to obfuscate and saying only 5 EVs on board. The next day, it jumped to 496 EVs. This further infuriates many people who are already very skeptical about the EV push from gov. This is the third similar incident in two years.
The leftists in US always praise Norway as a model country, especially on the EV push. Norway population is about 5.4MM and its sovereign fund is basically from the country’s oil/gas exports. Its EV subsidy is from oil and gas revenue. Wouldn’t you be cynical? Norway runs many ferry routes in North Sea and more southern area. No EVs are allowed on board. More and more people are increasingly skeptical, if not outright angry, about the ESG push from gov. There’s never an official study which passes the scrutinization. And citizens around the world are not even allowed to raise valid counter argument.
The inflection point (forever a cliche) would be insurance premium rising to an unbearable level for EV drivers. At this moment people who are not driving EVs are subsidizing EV drivers. At certain point people would file lawsuits against this practice when more and more EVs are on the road. I am also seeing bans preventing EVs from parking in big building underground garage or in townhouses. Some people would also want to sue their neighbors for parking EVs close to their properties. A few more cases of EV fires in the near future will surely make people really hysterical.
What our gov is pushing is not solving problems, only creating more problems and making certain group of people very rich. Just a scam. Everyday we see scientists publish papers with ‘desired data and results.” More research grant follows. Ain’t life grand if you just fall in line? An annual budget of 8B form NIH alone for cancer research, and there are no results after all these years. Yet the show goes on. I bet if you found a cure for cancer you won’t live to see tomorrow.
Now aren’t you cynical? Rightfully so.
It’s all about agendas and looking good.
Also some groups make a lot of money.
Personally, I like hybrids. They get great mileage too. Then there is driving slower. We did that in the 70s after the oil shock, the speed limits on the interstates were lowered to 55. Less gas consumption and as a bonus less fatalities. Funny how nobody is talking about driving slower.
We have a solar plant in CA on the way to Vegas that is mirrors reflecting onto central columns. Supposedly you get a bigger bang for your buck than with solar panels, and waste management should be simpler.
My advice is “think of the environment, but do what feels right for you, not what some public mouthpiece is saying to do”