The recalibration of the Nasdaq 100 and the expiry of options worth around $2 trillion are now over. The market’s attention now turns to a barrage of earnings reports, coupled with rate decisions from the Federal Reserve, European Central Bank, and the Bank of Japan, before the summer market lull commences in earnest.
Morgan Stanley seems to issue a seemingly regular mea culpa for underestimating the resilience of this year’s stock market, which thus far, has resulted in an 18% rise in the S&P 500 SPX, +0.03% and a 34% surge in the Nasdaq Composite COMP, -0.22%.
Chief Cross-Asset Strategist Andrew Sheets observes that forward earnings estimates for both global equities, mapped out by the MSCI All-Country World Index, and the U.S., using the S&P 500 as a yardstick, have remained static throughout the year. This implies that value enhancements have driven the entirety of market gains. In the past quarter-century, he notes, only two instances saw stronger growth in multiples – 2009 and 2020 – both of which were marked by severe recessions and substantial monetary easements, thus supporting the case for hiking valuations in anticipation of an eventual bounce back.
Sheets also refers to 1998 and 2019, when multiples rose even against the backdrop of a contracting Fed balance sheet and declining earnings per share. Notably, core inflation was pegged at around 2% during these periods. He observes, “Coincidentally, both 1998 and 2019 saw markets perform unfavorably in August-September, followed by multiple Fed rate cuts in the latter part of those years”.
However, Sheets points out that the real oddities transpire within the capital structure, where higher returns are being made on senior debt constructs as compared to their more junior counterparts, causing an unusual inversion.
He cites an instance, where the yield on investment-grade corporate bonds stands at 5.4%, surpassing the forward earnings yield for the Russell 1000, which is at 4.8%. Such a skew has only been more pronounced 2% of the time over the past two decades. In a similar vein, the yield on U.S. investment-grade real estate investment trusts is 5.8%, which exceeds the average U.S. commercial real estate cap rate, or the inherent real estate yield, of 5.4%. Furthermore, the gap between the yield on a collateralized loan obligation’s collateral and the weighted cost of its liabilities links to the 7th percentile of the last decade, both in the U.S. and Europe.
Sheets concedes that different narratives can be attributed to these unique scenarios of inversion, arguing that a strong growth scenario can justify higher debt relative to its underlying asset. He notes, “However, this squeeze, and even reversal, of the capital structure suggests that growth expectations have significantly evolved since the year began. Regardless of whether growth remains solid or decelerates, we believe that debt generally provides superior risk/reward, especially when this capital structure reversal incentivizes greater economic unwinding of leverage.”
