Market turmoil last week in bond and equity markets is emblematic of late cycle dynamics. In the latter part of the business cycle, growth is still strong; consumer spending and business investment are mutually reinforcing, but early signs of inflation begin to show. Prices begin to rise as demand outpaces supply because the economy runs into capacity constraints. Sometimes but not always, debt is used to finance nonproductive investments, such as in speculative bubbles. At this time, the central bank begins tightening policy.
The expectation of inflation and tightening results in higher bond yields as investors begin selling off bonds. There is a twofold effect from rising bond yields: bonds become more attractive on the margin relative to stocks, and discount rates increase, which decrease the present value of other financial assets. At the same time, stocks, having rallied from the economic growth of the mid cycle, approach cyclically high P/E ratios. As P/E ratios increase, equities’ earnings yields (E/P ratios) decrease mechanically, making stocks less attractive historically. What emerges at this point in the cycle is a sort of tug-of-war between bond yields and earnings yields, in which equities will periodically decline (leading to higher earnings yields) in order to stay competitive with bonds.
This push-and-pull dynamic may happen many times before a real recession. The late cycle gives way to a bust when the strength of bond yields, fears of impending inflation, and Fed tightening come to weigh more heavily on spending and investment. Below we show the ratio of equities earnings yields to bond yields for developed world countries relative to history (higher values mean that stocks are more attractive relative to bonds).
It is our view that there is still some time to go before the music stops in the United States. Though the Fed no longer describes policy as being “accommodative”, rates are not tight enough to materially slow spending. Though we believe inflation risks are mounting, inflation as a whole and in relation to the broader business cycle is still benign. Indicators of demand, we’ve noted, suggests a similarly sanguine outlook for growth, with some unease about Trump’s tariffs. However, as secular trade risks and cyclical inflation and yield worries increase, we believe more defensive positioning is warranted.
