Massive US government fiscal stimulus has supported household consumption and business investment, but at the cost of higher interest rates.
The main driver for markets over the last 18 months has been the outlook for policy rates, that is, whether the leading central banks would raise or lower them as they sought to tackle high inflation. The resulting change in bond yields would then drive equity markets.
This dynamic changed in August as US Treasury bond yields jumped by 40bp, even as market forecasts for the level that the benchmark US fed funds rate should reach this year hardly moved (see blue line in Exhibit 1).
US budget deficits and economic growth
What changed was the market’s assessment of the long-run level of policy rates, known as r-star or the neutral rate. This is the interest rate that is neither expansionary nor contractionary when the economy is at full employment.
The shift in the market’s estimate of r-star can be seen in the increase in the forecast for the long-run fed funds rate (the orange line in Exhibit 1). This rose sharply after rating agency Fitch cut its long-term rating of the US as a bond issuer to AA+ from the top tier AAA.
There are several factors which determine r-star, but one of them is the outlook for debt sustainability. Fitch’s downgrade was not by itself enough to lead to such a large move in bond yields, but it was a catalyst, reminding investors that US fiscal profligacy comes at a cost.
The Biden administration’s USD 1.9 trillion coronavirus relief package was financed by increased government debt issuance. Over the next 10 years, the Inflation Reduction Act is expected to cost anywhere from USD 391 billion to USD 1.2 trillion.
As a result, the US Congressional Budget Office sees budget deficits over the next 30 years reaching 10% of GDP (versus a pre-covid 20-year average of 4.3%), and the debt-GDP ratio approaching 180% (versus 98% today).
That deteriorating outlook should be reflected in (higher) government bond yields. It also likely not coincidental that government bond yields for another ‘fiscally challenged’ country, the UK, rose by even more than they did in the US, while the increase in yields on Bunds was half as large.
Another driver of a higher neutral rate is economic growth. US GDP was still rising at 2.4% (annualised) in Q2 (itself a function of the fiscal stimulus), even after a cumulative 525bp increase in the US Federal Reserve’s policy rates. That suggests the economy can sustain a higher level of interest rates than had been thought.
What now for equity markets?
This month’s sell-off in equities has primarily been a function of higher interest rates which feed directly through to a higher discount rate (and lower net present value) for equity prices. This has been a salubrious development, particularly for highly valued US growth stocks. Valuations for the NASDAQ 100 index had reached an uncomfortably high 28x price-to-forward-earnings (P/E) ratio earlier this year, reversing about half of the decline from 2022. This was worrisome as it had occurred even as real yields were rising (higher real yields should normally drive valuations lower).
This month’s sharp increase in US bond yields has reduced the P/E ratio to 25x, which is still somewhat high, but given the prospect for artificial intelligence-boosted profits in the tech sector it is not necessarily unsustainable (see Exhibit 2).
Assuming Treasury yields stabilise (or even decline) from here, the pressure on equity market valuations should ease and earnings should return as the primary driver of equity performance. Consensus estimates still point to year-on-year gains in profits in 2024 and, for now at least, earnings revisions have been positive for US equities, even if they are less so for other markets (see Exhibit 3).
Given the recent disappointing purchasing manager indices (PMIs) and retail sales data in Europe, earnings forecasts for this region may now weaken further. Europe has faced an increase in central bank rates nearly as large as that in the US, similar rates of inflation, and similar stress from Covid lockdowns, but it has not benefited from a similar amount of fiscal stimulus. Economic growth, and corporate profits, reflect that difference.
Momentum in China is already quite weak. Investor sentiment is unlikely to turn before the government takes more decisive measures to address the property sector’s problems. The sharp rebound in the local market at the end of July, when the MSCI China index gained 9% in one week on news of a government stimulus package, shows the potential for gains, however. Chinese equity valuations are comparatively low, on both an absolute and a relative basis, but a catalyst is needed to close the gap.