Equity risk premium is still not pricing a growth slowdown
Price-to-earnings (P/E) multiples have contracted year to date as a result of weak price performance, yet earnings revisions have continued to move upward. While these positive earnings revisions don’t appear to corroborate the cautious qualitative forward guidance given by corporate issuers, the earnings yield on the S&P 500 Index has continued to rise. And with the forward P/E of the index retreating from 22.0x at its 2022 peak to 15.9x as of this writing, it’s easy to say that valuations have substantially cheapened—but we caution on getting too excited.
A look at the equity risk premium (the S&P 500 Index earnings yield less the U.S. 10-year U.S. Treasury) shows us that it’s clocking in at 3.18% and is still low. While market participants are busy trying to find the bottom in equities, we aren’t confident that the equity risk premium is fully compensating investors for the growth slowdown that we think the United States will experience this year; in fact, the earnings yield is likely to decline if earnings are revised downward. This last scenario is likely to be the case as profit margins erode, the U.S. Federal Reserve tightens, and demand moderates. We have to ask ourselves: Is an earnings yield roughly below where it’s been over the past decade really compensating equity risk given the macro outlook over the next 6 to 18 months?
The story doesn’t end there though—starting points matter: If an economy is on relatively strong footing heading into a technical recession, it will have more of a buffer against the shock. We use money velocity as a proxy for that buffer. Specifically, rising money velocity indicates stronger economic activity, while a falling velocity indicates weaker activity. When we screen for periods in which money velocity was falling into technical recessions, the list is much shorter, with just 6 episodes. Notably, the average drawdown increases markedly to 48.7%, and the average duration increases to 510 calendar days.
So far, 2022 is consistent with our assertion that a GDP recession in the United States is yet to be priced in. But with money velocity low and falling, the realization of recession has the potential to be very negative for price action, if history is any guide. We would expect continued market choppiness as investors debate the recession outlook. With equity markets discounting the economy roughly six months out, it would suggest that a resolution to when a U.S. recession may begin may not be settled conclusively until the last quarter of 2022.
The neutral rate of work from home
While work from home continues to dominate discussions in the workplace, we’ve continued to ask ourselves what the neutral rate of work from home in the postpandemic new normal is.
It’s estimated that only 50% of all U.S. workers hold jobs that actually allow them to work remotely. That makes about 66 million remote-capable workers, accounting for about 20% of the U.S. population.
Once we isolate the number of remote-capable workers, we look to a recent Gallup survey that followed 140,000 respondents through the pandemic to obtain insight into their working arrangements. The survey asked remote-capable respondents where they were working before the pandemic and where they anticipated working in 2022 and beyond. Comparing pre- and postpandemic results, exclusively remote work increased from 8% to 24%, hybrid was up from 32% to 53%, and fully on-site workers fell from 60% to 23%.
If you assume that the new class of hybrid worker commutes an average of 2.5 days per week, we could see a 35% reduction in total office visits on an annual basis for remote-capable workers compared with 2019. This means 35% fewer people commuting during rush hour, fewer people supporting businesses near the workplace, and a reduction in the consumption of goods and services essential for an in-office lifestyle. How working arrangements evolve will also affect where people live, as well as interstate migration and corporate travel. Furthermore, this data would suggest that approximately 15% of remote-capable workers that were working exclusively remote in 2022 will trend to their neutral rates of hybrid or on-site arrangements. But for those still waiting on more juice in the reopening trade, we caution that this represents only about 10 million people, less than 3% of Americans.
How does a more aggressive Fed narrative transmit to Asia?
The Federal Reserve (Fed) delivered the biggest one-time increase to the Fed funds rate in 28 years on June 15, raising the policy rate by 75 basis points. It also signaled a more aggressive policy trajectory, resulting in significant tightening in global liquidity conditions, leaving global central banks scrambling. In Asia, this new narrative for the Fed is creating considerable pressure for central banks to accelerate their own tightening.
Broadly speaking, the downdraft of higher rates and the delayed peak inflation narrative will weigh on consumption and investment growth at a time when Asia’s recovery from the pandemic is still incomplete, and financial stability risks are increasing. The longer the disruption from higher rates and tighter liquidity goes on, the greater the risk of demand and supply shocks morphing into a liquidity/funding shock, further denting economic growth through a domestic credit or external funding stock. When an economy has built up significant domestic debt liabilities, slowing economic growth can hurt corporate earnings and their ability to service debt. In turn, this can lead to unemployment, reducing the ability of households to service their consumer and mortgage debt.
A sudden external funding squeeze is another potential liquidity risk for Asia. Balance of payment funding pressure can intensify when the U.S. dollar is too strong and when there are large capital outflows. Risk aversion can also result in tighter credit conditions when trying to raise external funding or roll over existing foreign currency liabilities.
By calculating Z-scores for each of these variables, we find that Hong Kong, China and South Korea are most exposed to domestic credit risk from slowing economic growth, while Hong Kong, Australia and Singapore are most vulnerable to external funding risks. The relative bright spots are Taiwan, Japan, Indonesia, Philippines and Malaysia.
1 The S&P 500 Index tracks the performance of 500 of the largest publically traded companies in the United States. It is not possible to invest directly in an index.
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