We've seen a significant global economic recovery gain steam this past year, with global equities following suit. U.S. employment data suggest hiring activity has gained momentum while indicators of economic activity across the world (manufacturing and purchasing manager data, regional Fed indices, etc.) have all registered readings in the green, indicating growth above expectations. Flaring geopolitical risks, slowing growth and negative pricing pressures in Europe have largely acted to suppress global interest rates in an otherwise positive economic environment.
We have a dichotomy forming between lower interest rates and higher equity prices. Lower interest rates have portended lower growth and inflation, while higher equity prices don't seem to agree with that explanation. Here we have an inconsistency that leads to some obvious confusion.
When comparing the S&P 500's E/P ratio (one divided by the P/E) to the 10-year treasury yield, it becomes obvious that there is an empirical relationship between the two. This is the "Fed Model," in which the red line being below the blue line indicates stocks are overvalued and vice versa.
The problem with such a simplified model is that it says nothing about the future. If you'll notice, when S&P 500 financial companies were hemorrhaging losses in 2009, reducing S&P earnings, the E/P shot downward and indicated that stocks were overpriced - even at their lows. Some of this problem could be remedied by using an E/P ratio constructed from operating earnings instead of GAAP earnings (which include one-time losses).
The chart currently says treasuries are expensive relative to stocks (or vice versa). The Fed model leaves a lot to be desired, as it says nothing of corporate bond risk relative to equities. Despite this, it doesn't appear unjustified to use this model as a rough tool to take the long view. The spread between treasury yields and the E/P as a percentage of the interest rate level is near record highs. If the model is to be followed, this means the S&P 500 is either worth double what it is today, or bond yields could be mispriced significantly. Given what's about to follow, I'd say the latter is true. Something in one of these markets is very wrong - likely not stocks because they are so close to average historical valuation levels.
In valuation models, cash flows with a lower discount rate result in a higher security price, with everything else being equal. In simplistic terms, the discount rate can be thought of as being composed of the sum of a risk-free rate at a certain maturity and the risk premium that is justified by the specific asset. In intermediate-term high-yield bonds, it might be 5% being composed of the sum of 2% 5-year treasuries and a 3% market-determined credit risk premium. In stocks, because they resemble long-term securities in maturity, it could be composed of 3.3% 30-year treasuries and a 5.4% equity risk premium, or 8.7%.
Generally, the risk premium is negatively correlated with the risk-free rate. That is, when investors are fearful, the risk premium rises as investors demand more compensation for risk. Offsetting this, investors flood into risk-free safe-haven assets, depressing the risk-free rate. More often than not, in times of economic stress, the risk premium rises much more significantly than the risk-free rate falls, causing the total required return on assets to rise.
Right now, we have a seemingly unusual situation of interest rates falling on a fear-bid while risk-premiums are not rising. This is a market inconsistency. Following this logic, if global conflicts continue to drive the safe-haven bid and depress global interest rates further, while not hurting the real economy (by driving risk premiums higher), stock prices and bonds will both continue to rise. It's a bizarre and arguably fortuitous (for stock buyers) feedback loop.
Now, one more decomposition - that being the risk-free rate itself. The dominant theory states that the risk-free rate is determined by the combination of real interest rates, inflation expectations, and the term premium. Often, the term premium is embedded into presentations of the real interest rate (in our case, TIPS yields include the term premium).
Simplified, the decomposition turns into observable factors: Economic growth prospects and central bank liquidity factors determine real interest rates, while inflation expectations readily are available from market data (TIPS over nominal spreads) and survey data.
The term premium remains and is the additional return bond investors are requiring to take extra interest rate risk. The market-expectations hypothesis of term structure states that the long-term rate should be composed of reinvesting money at the short-term rate over and over again. The idea here is that you could replicate a 30-year bond by just buying 90-day bills and reinvesting every quarter. When this reinvested short-term investment yield differs from the market long-term yield, this difference is accepted to be the term premium.
The term premium exists generally due to the composition of investors in the market. If pension plans have unmet long-term liabilities and represent a significant amount of dollar flows, pension managers might be forced to allocate more heavily in long-duration treasuries, depressing yields (and the term premium). Other possible drivers of term premium include portfolio managers who in aggregate decide whether long-term interest rate exposure is a "risk" (a bad thing) or a "hedge" (a good thing), price-indiscriminate buyers (central banks who allocate by policy decision), and short-term allocators (flight-to-quality buyers and central bank front-running bids).
It is arguable whether the price impact on term premium from central bank fund flows alone is meaningful, as the underlying policy decisions may have a larger impact on inflation and growth factors than on the term premium. For example, if a central bank decides to distribute money from helicopters directly to the population, it may increase growth and inflation expectations by 2% and only decrease the term premium by a much smaller 0.5%.
As shown below, market inflation expectations remain robust and are not decreasing. This suggests that an investor should not put much stock in casual journalistic reports of market consensus is that deflation or disinflation is on the way.
On and beneath the surface, economic growth, one proxy to the real interest rate, is continuing to accelerate. The economic recovery continues to pick up steam, and central banks have solidified policy support.
As pictured below, U.S. real GDP growth on a lookback basis is continuing to recover back to the long-term trend line, slightly above 2.0% per year. The IMF has current 2015 and 2016 GDP growth forecasts (a decent proxy for longer-term growth expectations) at 3.0% per year, well above levels in this quantitatively calculated chart.
In addition to expectations of economic growth, real interest rates serve to measure the available financial liquidity in the markets. As shown below, TIPS yields (a proxy for real interest rates) spiked upward as market stress escalated in a post-Lehman environment in 2009. As the Federal Reserve responded in subsequent years with multiple rounds of easing and emergency measures, real interest rates significantly fell to below normal and historical levels of approximately 2% (on the 10 year).
Against this backdrop of real interest rates is the red line, a rolling sum of six prior monthly percent changes in the U.S. unemployment rate. Despite the internals of the unemployment rate number being arguably weaker than prior recoveries (look to lower labor participation rates), there is still undeniable substantial improvement when examined from a historical context. This serves to normalize the Federal Reserve's policy response to let real interest rates ease upward.
I maintain that current long-term rate levels are not sustainable. The term premium may sit this low largely because long-term interest rate exposure is viewed by portfolio managers more than ever as a "good" rather than a "risk," because it recently has offered some hedging value to stabilize equity portfolios in times of uncertainty. Likewise, a continued depression of real interest rates will depend on continued easing by the Federal Reserve. With the Federal Reserve no longer increasing its balance sheet by October, I expect rates to respond as market participants consider the risks to an upside readjustment in real rates.
A simple re-composition of the risk-free rate model points to a 30-year yield at a target of between 4% and 5% (with a normalized 2% real interest rate and a 2.5% inflation expectation), versus the market current sitting at 3.23%. This points to a potential unlevered reward of 14%-32% on a short position of the 30-year security, not counting annual carry costs. One may gain approximate exposure to the position through shorting the TLT, ZROZ, or UB futures. As of this moment, this is a high-conviction position in Counterpoint's Unconstrained portfolio.
Disclaimer: The information contained in this article should not be construed as personalized investment advice, and should not be considered as a solicitation to buy or sell any security or engage in a particular investment strategy. Past performance is no guarantee of future results.
Counterpoint Asset Management is a state registered investment adviser with its principal place of business in the State of California.
Disclosure: The author is short TLT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.