Bonds will determine where the equity bear market will go next


The US equity bear market may be approaching the end of Act I (adjustment to higher interest rates), and many investors are eyeing Act II (adjustment to lower earnings). But the transition is taking longer than expected, and some are wondering if Act II is really happening.

That’s reasonable, and that uncertainty could lead to some compelling short-term rallies in a battered stock market.

Of course, the selling of stocks in the first 10 months of 2022 was mainly driven by soaring Treasury yields, with the 10-year note hitting 4.23% on Thursday, the highest since 2008. As Valuation 101 we learned, the jump in risk-free rates increases the cost of capital for companies and reinforces the relative attractiveness of sovereign bonds compared to equities. Investors are refusing to pay so much for the same cash flows and price-earnings ratios are shrinking. Here’s how forward P/E ratios have tracked 10-year Treasury yields so far in 2022:

If yields rise, P/Es will naturally continue to fall, but the balance of risk for sovereign bonds is nowhere near as bad as it was a few months ago. Yields are already approaching levels consistent with relatively hawkish monetary policy. In other words, P in P/E ratios may stabilize soon, based on interest rates alone.

This introduces Act II of the bear market: growth.

Overall, Wall Street has made only modest downward adjustments to the earnings outlook this year. For all the recession hysteria, the consensus earnings forecast for 2023 is just 2% below where it started the year. Granted, the headline figure is dampened by Energy earnings, and analysts have been more conservative on vulnerable consumer discretionary businesses. But an average recession lowers overall earnings per share by 31%, and the median forecast in a Bloomberg survey of economists now puts a 60% chance of one in the next 12 months.

So why aren’t analysts more pessimistic about their earnings outlook?

One obvious reason is that hard data gave them no concrete reason to be. Retail sales have mostly continued to grow or, at worst, stagnated in nominal terms, and unemployment remains extremely low. Meanwhile, third-quarter earnings look poised to confirm the economy’s momentum.

Consumers are clearly fed up with inflation, but they continue to spend and support corporate profits. At first, they were able to tap into large cash reserves built up during the Covid-19 pandemic. More recently, they maintained their lifestyle by resorting to credit. This can’t go on forever, and we may have reached an inflection point, as Morning Consult’s head of economic analysis, Scott Brave, told me in conversation Wednesday. But that’s not yet in the hard data, and even then it will look like a gradual deterioration in real spending, not a crash.

At the current pace, the economy could continue to send mixed signals through 2023. Bloomberg Economics, which predicts a recession, does not expect it to start until the third quarter of next year. Models are usually inaccurate in timing, but on average it takes a while for these things to get worse, as Anna Wong, Bloomberg’s chief U.S. economist, points out. She noted that demand has even rebounded a bit in recent months.

Indeed, the long slog ahead can be seen in the Federal Reserve Bank of New York’s weekly economic index, an indicator of real economic activity scaled by the four-quarter growth rate and based on data at high frequency. This suggests that the economy continues to cool after the unusual reopening dynamics of the Covid-19 pandemic. A rough trendline exercise suggests that, if the downturn were to continue at the current pace, the indicator would not even flirt with negative territory until March or April.

So there we are: Act I of the bear market could conceivably end, provided inflation starts behaving in line with the Fed’s forecast, and traders can’t find a lot of near-term catalysts to lift. the curtain on Act II. Cue the annoying bulls.

Naturally, this backdrop is fertile ground for short-term rallies, and that’s exactly what US markets have seen, starting with the otherwise inexplicable 2.6% rise in the S&P 500 Index last week. a day when the Bureau of Labor Statistics reported that core inflation had reached a four-decade high. From Thursday’s lows to Tuesday’s highs, stocks soared 7.8%, and several strategists made the case for further upside:

• Morgan Stanley strategist Michael J. Wilson wrote this week that a rally in the bear market could take the S&P 500 to 4,000 and he wouldn’t rule out an even bigger jump to around 4,150.

• DataTrek Research co-founder Nicholas Colas said a meaningful rally in the bear market was possible, but that “it’s critical that interest rates come down from here to support any further sustainable upside.” US large caps.

This point on rates seems critical. With all the ripples in the economy, it’s conceivable that bond yields could come back down for a while. But as the Fed has pledged to rein in high and volatile prices, policymakers are likely to maintain a firm floor under bond yields until inflation appears to be on track towards the Fed’s 2% target. (1), which could take months to materialize in the future. data even in the most optimistic scenarios.

Meanwhile, growth and consumer activity are failures for the bulls. They may not confirm anyone’s bearish narratives in the immediate future, but any sign of strength in these indicators would only encourage Fed hawks to do more. Thus, in the short term, the fate of equities remains entirely in the hands of monetary policy and the bond market. Whether or not Act II of the bear market materializes, the intermission itself could be almost as dramatic as the play.

More from Bloomberg Opinion:

• Gilts care more about supply than Tenant #10: Marcus Ashworth

• Why breaking the QE addiction is such a struggle: Daniel Moss

• Krugman-Summers Inflation Dispute Explained: Karl W. Smith

(1) Bloomberg Economics forecasts a terminal rate of 5%, but notes that even a terminal rate of 6% could be possible if the Fed needs to revise its estimates of the natural unemployment rate upwards or if productivity has fallen.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg reporter in Latin America and the United States, covering finance, markets, and mergers and acquisitions. Most recently, he served as the company’s Miami office manager. He holds the CFA charter.

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