The cost of debt is already up by 375bps and is thus far hurting those banks that have become forced sellers due to deposit outflows. Corporate bond spreads tend to broaden in recession by at least 200bps, making the cost of debt pro-cyclical. Further pro-cyclicality comes via the use of the Baa designation, which is fixed, whilst the constituents are not. In recession, extensive de-rating can only be expected.
Unfortunately, the cost of equity is also pro-cyclical, because earnings recession fears initially act to force share prices, and hence the Price Earnings (PE), down and the earnings yield up. The Weighted Average Cost of Capital (WACC) bottomed at 2.4% in July 2021 and it is already up at 5.7% today. Yet, a recession may result in a WACC capital of more like 7.5%, and at the very time, that earnings momentum would have turned negative as well.
Please click on the link below if you prefer to listen to the articleThe US 30-year Treasury Bond Yield
The US 30-year Treasury bond yield has comprehensively broken its 4-decade-long bull market, as indicated by the red circle in Figure 1 below. Whatever transpires in the near term, it will be very hard for the Fed to prove to investors that, in the longer term, things will eventually return to the previous trend.
Figure 1: US 30-year US Treasury Long Bond Yield (%)
Inflation
Inflation does not just cause more inflation, it also initiates a sea of change in nominal yields. Using the 1987 crash as an example, equity markets can be slow to notice, let alone respond to, rising Treasury yields, which increased by 320bps in nine months from 7.01% to 10.22% reflecting a 350bps rise in CPI, but when they do take notice eventually, the results can be drastic.
Since the August 2020 record low of 0.5%, the 10-year UST yield has risen by 350bps, enough to drive the equity earnings yield up from 2.9% in April 2021 to more than 5.4% in October last year. However, it has, at least for now, fallen back to 4.5%. Although equities still yield more than Treasuries, neither yet yields more than CPI.
Figure 2: US Inflation Cycles, 1961-1981 (%)
Having fallen so far behind the curve, the Fed remains determined to keep tightening, despite the fact that money supply has shrunk by $900b over the last ten months and easing supply chain pressures are pretty much back to normal as indicated by Figure 3 below.
Figure 3: Supply Chain Pressure & US CPI Lagged 2Qs (%)
Jay Powell’s hawkish testimony to the Senate Banking Committee has put another 50bps rate hike this month back on the table, though the SVB fallout may make that debatable, even though other evidence suggests the Fed has already done more than enough to trigger a recession. This raises the distinct possibility that the Fed will once again overshoot, this time driving the economy into recession. The Bank of America CEO Brian Moynihan had already stated that his team expects a technical -0.5% to -1% per quarter recession from Q3 2023 through Q1 2024. Yet he still does not expect the Fed to start cutting rates until Q2 2024. History however, suggests that the chances of either scenario are remote.
First, a cumulative 2.2% economic contraction would hardly constitute a meagre technical recession. Of the dozen post-War US recessions, almost half saw the economy contract by less than 2.2%. The sort of scenario Moynihan is imagining is closer to just a recession. Clearly, his fellow senior bankers feel the same, with over 44% net of those surveyed reporting tightening lending standards, a rate historically equal to recession.
Figure 4: Senior Loan Officer Survey – Banks Tightening Credit
Second, it is entirely normal for the course for the Fed to tighten, often aggressively, right up to the triggering of outright recession, before then switching course even more aggressively, but once it realizes what it has done. The recurring problem the Fed faces is that it wants to appear data-dependent, but has chosen to rely almost entirely on lagging data to be dependent on. Typically, therefore, the Fed is still hiking almost up to the day recession hits, before then cutting steeply right the way through and beyond its end as indicated by the red circles (Figure 5 below). The best measure of whether the bond market believes the Fed has overdone it is the yield curve, which hasn’t been this inverted since October 1981, on the eve of the 1982 recession. Remember that the yield curve always steepens sharply once recession takes hold and the Fed cuts.
Figure 5: US Fed Funds Rate Reversals & Recession (%)
Dead Man Walking
Thus, despite all Fed protestations to the contrary, the whole point of tightening monetary policy in the face of inflation, is to destroy demand: in other words, to force a landing. Whether that landing is soft or hard is of only secondary importance to the Fed, albeit of primary importance to everyone else. There is plenty of evidence that inflation will decline over the next few months all on its own. Yet, despite all this the Fed has been signalling higher rates for longer and now Powell seems to be flagging a 50bps rise at the next FOMC. Of course, much of this could be designed to signal intent and talk down expectations, but the stated reasons are sticky inflation and robust employment, which are both lagging indicators.
Weighted Average Cost of Capital
It is estimated that the S&P 500 WACC, by weighting the Baa yield and the equity earnings yield by the debt to- equity ratio (total liabilities divided by total equity). The end-Feb WACC is already 5.7%, the highest for fifteen years as indicated by the figure (Figure 6 below).
Figure 6: Est. US Weighted Average Cost of Capital (WACC, %)
Cost of Debt
The WACC consists of two components, the largest being the cost of debt and Baa yields which have risen 375bps since the end 2020 low. Yet St Louis Fed data shows that the Moody’s seasoned Baa corporate bond yield is currently only 179bps above the yield on the benchmark 10-year US Treasury, a spread which is unnaturally close to the bottom end of the 40-year range as indicated by the figure below (Figure 7). If we are indeed nearing recession as excess savings dry up, in that case the spread tends to widen to more like 400bps on average as the risks of default increase. In other words, although the WACC is at an almost 15-year high, its main component the Baa yield, despite having already risen 230bps in a year, still seems substantially, too low.
Figure 7: Moody’s corp. Baa Bond Yield Premium to 10-yr UST
This means that firms rolling over debt will now face higher interest burdens as existing debt matures, but this is a slow burn drag that takes time to be felt across the board. An early indication of just how difficult that may be though, comes from the other side of the coin. Banks hold bonds as assets, but in the last 18 months, the value of even risk-free 10-year US Treasuries has fallen by 20%. Even the 5-year UST has fallen by 14% in value. When faced with deposit outflows, crypto-lenders Silvergate and New York City-based Signature Bank, as well as Californian tech start-up bank SVB Financial were all recent forced sellers of bonds held as liquidity buffers. For Silvergate, the losses on bond sales eradicated capital and tipped the firm into bankruptcy. In the case of SVB, bond losses averaged at 8.6% of face value which, for a highly leveraged sector, proved a death sentence. The $92b of SVB’s Hold To Maturity (HTM) assets would likely be even longer duration than the 3.6-year average for their $24b of Available For Sale (AFS) holdings.
Generally, banks will redesignate out-of-the-money securities from AFS to HTM , but this accounting trick is no help when deposit outflows need to be rebalanced with asset disposals. Ironically, as QT has reduced bank reserve deposits at the Fed by almost $1.3t since end 2021, the Fed’s liquidity rules have forced banks to replace lost reserves with increased securities holdings which, if long duration, have declined in value precipitously. The Fed’s efforts to make the banks more liquid therefore, have unintentionally contributed to making them less solvent, as SVB’s fortunes prove. That said, the sector liquidity position appears fine for now. Although QT has driven reserves down from their $4.2t peak as indicated by the blue line (Figure 9 below) this is still some $1.5t higher than the level they had declined to in 2019, when the system became stressed. Seen as a percentage of total assets as shown by the red line reserves are currently at 13.5%, whilst in 2019, they had fallen to about 9%, when the trouble first started. On this point alone, the Fed still has at least a year of breathing space.
Figure 8: 10, 5 & 2-year US Treasury Price Indices (from 100)
Generally, banks will redesignate out-of-the-money securities from AFS to HTM, but this accounting trick is no help when deposit outflows need to be rebalanced with asset disposals. Ironically, as QT has reduced bank reserve deposits at the Fed by almost $1.3t since end 2021, the Fed’s liquidity rules have forced banks to replace lost reserves with increased securities holdings which, if long duration, have declined in value precipitously. The Fed’s efforts to make the banks more liquid therefore, have unintentionally contributed to making them less solvent, as SVB’s fortunes prove. That said, the sector liquidity position appears fine for now. Although QT has driven reserves down from their $4.2t peak as indicated by the blue line (Figure 9 below) this is still some $1.5t higher than the level they had declined to in 2019, when the system became stressed. Seen as a percentage of total assets as shown by the red line reserves are currently at 13.5%, whilst in 2019, they had fallen to about 9%, when the trouble first started. On this point alone, the Fed still has at least a year of breathing space.
Figure 9: US Bank Reserves ($bn) & as % of Total Assets
Inherent Pro-cyclicality
Theoretically however, the use of the Baa rating to estimate cost of debt has another inherent, pro-cyclical, flaw. The use of the fixed Baa rating disguises the fact that debt gets derated in recession. Therefore, the components of the Baa rated silo are not the same names in recession as they were pre-recession, with it being usual for many, if not most, to be downgraded to junk. The spread between Baa is only 1 to 3 notches above junk, so a lot of issuers can become un-investable, causing their cost of debt to blow out, quite quickly. We should assume that in the event of a recession, for the current crop of Baa borrowers, spreads will not just widen another 200bps but, being downgraded, their spreads will effectively widen far more.
Cost of Equity
So, the stock market shouldn’t be complacent, as it was in nineteen eighty-seven, just because it usually takes time to fully realise the compression of margins due to the increased cost of debt. S&P 500 EPS peaked in Q2 2022 after an almost 12-year unbroken run. The extent of the potential earnings downside should not be underestimated, in spite of the strong retail flows into the market since October. The equity earnings yield, the junior partner within the WACC, is just as prone to dangerously excessive procyclicality as the cost of debt component is. Apart from the obvious point that recession impacts earnings, on average over the last eight recessions by 27% in real terms, there is also a visible problem with the overstatement of reported earnings towards the end of each cycle. If we compare S&P 500 reported EPS as shown by the blue line (Figure 10), with economy-wide, after-tax corporate profits as shown by the red line, it appears that listed firms, whether due to accounting bias, the pressure to achieve forecasts, overconfidence, or some other bias altogether, tend to overstate earnings in the latter stages of each cycle as indicated by the green circles. So much so, in fact, that despite the 2-to-3-year lead time, evidence that EPS have pulled away from wider economy profits might constitute another reliable leading indicator that a recession is overdue.
Figure 10: US After-Tax Corp. Profits Rebased to S&P 500 EPS
Mean Reversion
Typically, these two-profit series mean revert, with EPS falling back in line with, or even below, economy-wide accounting profits in the aftermath of recession. This historic tendency implies that reported EPS is currently 15% higher than it should be according to more rigorous accounting principles. In a similar vein, Morgan Stanley analysts recently estimated that the gap between reported earnings and cash flow is at a 25-year record wide, which they ascribe to a mix of excess inventory and capitalised costs. Either way, the tendency for EPS to flatter corporate profitability towards the top end of each cycle, means that earnings reversion when recession hits is harder on Wall Street than it is on Main Street. This in-built volatility matters because the faster earnings decline, the higher the cost of equity rises, exacerbating the impact a recession would already be having on the pro-cyclical widening of corporate bond yield spreads.
Shiller PE
One way around the procyclicality of earnings is to flatten the earnings cycle by dividing the index by the 10-year average of EPS. The trouble with this Shiller Price Earnings measure is that it throws the downside risks from an earnings recession into even sharper focus as indicated by the figure below (Figure 11). The S&P 500 might not appear on the face of it to be too grossly overvalued on 22x, especially considering that the 50-year average PE multiple is only marginally lower at 17.4x. However, share prices are 32x the smoothed average EPS over the last 10 years. This is uncomfortably close to both the 1999 and 2021 highs, and the magnitude of the potential drawdown is clear. If recession hits, it would be reasonable to expect the market to discount reported earnings reverting back to the 10-year Shiller trend; and that would point to a 30% decline in share prices.
Figure 11: S&P 500 PER & Shiller PER (x)
Unfortunately, the EPS does indeed tend to fall back to its 10-year average when recession hits, as indicated by the green circles (Figure 12), which corroborates the possible 30% earnings retrenchment. Either way, downside risks now predominate over any upside potential offered by lowly 2023 EPS growth estimates of 1 to 2%.
Between February 2020 and April 2022, US M2 broad money supply, banknotes, and customers’ bank deposits, expanded by $6.7t, only $3t of which reflected an increase in commercial bank credit. The $3.7t remainder was the net result of the Fed’s QE. Nominal GDP rose $4t over the period, but real GDP increased by barely $700b, meaning more than three quarters of the impact from money printing was inflation, a surprise to few outside the Fed’s money-ignorant groupthink.
Excess Savings
Over time, households seem to prefer to hold deposits as indicated by the blue line (Figure 13) equivalent to roughly six months of annual GDP. This suggests that household sector excess savings which is indicated by the green circle will have become fully subsumed into nominal GDP as shown by the red line by year-end. It will almost certainly be sooner than this. Poorer households’ excess savings are drying up faster than richer households. Because the poor have both a higher propensity to consume and a higher demand for precautionary deposit balances than they were able to achieve pre-COVID, the negative impact on consumer demand will more than likely pre-date the realignment of savings with GDP
Cognitive Dissonance
For US businesses on the other hand, excess savings are already very much a thing of the past as shown by the green circle (Figure 14). From now on, firms seeking working capital will no longer be able to self-fund and will instead fall prey to the rising cost of debt. With cash-rich retail investors throwing the last of their excess savings into the stock market, whilst at the same time firms’ own finances have already run out of road, the prospects for superior equity returns look bleak.
Figure 12: S&P 500 EPS & 10-year Average EPS ($)
Between February 2020 and April 2022, US M2 broad money supply, banknotes, and customers’ bank deposits, expanded by $6.7t, only $3t of which reflected an increase in commercial bank credit. The $3.7t remainder was the net result of the Fed’s QE. Nominal GDP rose $4t over the period, but real GDP increased by barely $700b, meaning more than three quarters of the impact from money printing was inflation, a surprise to few outside the Fed’s money-ignorant groupthink.
Excess Savings
Over time, households seem to prefer to hold deposits as indicated by the blue line (Figure 13) equivalent to roughly six months of annual GDP. This suggests that household sector excess savings which is indicated by the green circle will have become fully subsumed into nominal GDP as shown by the red line by year-end. It will almost certainly be sooner than this. Poorer households’ excess savings are drying up faster than richer households. Because the poor have both a higher propensity to consume and a higher demand for precautionary deposit balances than they were able to achieve pre-COVID, the negative impact on consumer demand will more than likely pre-date the realignment of savings with GDP.
Figure 13: US Household Sector Deposits & 6-month NGDP ($bn)
Cognitive Dissonance
For US businesses on the other hand, excess savings are already very much a thing of the past as shown by the green circle (Figure 14). From now on, firms seeking working capital will no longer be able to self-fund and will instead fall prey to the rising cost of debt. With cash-rich retail investors throwing the last of their excess savings into the stock market, whilst at the same time firms’ own finances have already run out of road, the prospects for superior equity returns look bleak.
Figure 14: US Business Sector Deposits & NGDP ($bn)
Conclusion
A deterioration in the WACC, already up by 300bps this cycle, can take time to feed through into an equity derating, but is a warning that should be heeded, nonetheless. The cost of debt is already up by 37bps, though this seems to be punishing the banks ahead of the borrowers for now, that will not last. Corporate bond spreads tend to widen in recession by at least 200bps, making the cost of debt pro-cyclical. Unfortunately, the cost of equity is also pro-cyclical, because falling earnings apply downward pressure on the earnings yield. Back in July 2021, the WACC bottomed at 2.4% by our calculations and it is already up at 5.7% today. However, a recession, by widening the Baa spread and depressing the equity earnings yield, could easily result in a WACC almost of 7.5%, and at the very time that earnings momentum has turned negative.
With both the cost of capital and average wage settlements running at around 6%, when inflation drops below this level, US firms’ near-record-high profit margins (Figure 15) are set to get squeezed by a third, in other words, by at least 400bps, which implies a 30% decline in the S&P 500. Equity risks appear considerable, whilst the potential rewards, considering slowing earnings growth, the not insignificant prospect of recession and an already punitive cost of capital, look miserable.
Figure 15: US Corporate Profit Margins (%)
