The Federal Reserve has been on a near-singular mission in 2022 – to tighten US financial conditions and stem broadening inflation pressures. A combination of a steeper policy path, a stronger US dollar, and wider credit spreads has sharply altered the macro environment. While the S&P 500 has outperformed the MSCI All Country World Index in ten of the last twelve years, we view the current policy set-up as less supportive of US equities compared to global investments. Accordingly, the BlackRock Global Tactical Asset Allocation (GTAA) team has favored allocations to Eurozone and Japanese equities and has been playing US equities from the short side.
Procyclical monetary policy by the Fed has amplified tightening financial conditions
Typically developed market central banks seek to engage in what is known as “countercyclical monetary policy”. That means loosening policy when growth is slowing and “taking away the punchbowl” when growth is strong. Post-COVID policymaking has not stuck to this playbook. Large fiscal easing, successive waves of lockdowns, and numerous supply chain constraints resulted in procyclical monetary policy in the US in 2021. In other words, US growth was accelerating, and despite that, the Fed kept stimulating the economy further.
Fed policy in 2022 has continued to be procyclical, but now in the opposite direction. Growth and economic activity have been slowing while monetary policy has become more restrictive. Supply constraints stemming from Russia’s invasion of Ukraine and China’s zero-COVID policy have intersected with historically tight US labor markets. The resulting acceleration of inflation and wages has catalyzed the Fed to seek to rapidly cool demand. The effect has been a sharp tightening of financial conditions in the US.
This chart below shows our proprietary GTAA US Financial Conditions Indicator. This indicator seeks to measure whether financial conditions are tightening (indicated by negative values) or loosening (positive value). It does so by aggregating a range of data series like borrowing spreads, loan volumes, and the value of the US dollar. The year-to-date tightening has been both rapid and substantial.
US financial conditions have tightened rapidly
Source: BlackRock, Datastream as of 31 May 2022. For illustrative purposes only.
Rising corporate bond yields and waning corporate profit growth
One contributor to tighter financial conditions is higher yields on corporate bonds. One popular framework (known as the “Fed Model”) for assessing the relative attractiveness of US equities compares the earnings yield of the S&P 500 Index with US Treasury yields. The chart below shows a modified version of this where we compare the trailing free cash flow yield of the S&P 500 versus prevailing 5-year US corporate bond yields. The large year-to-date sell-off in corporate bond yields has inverted the rank ordering of the two that has persisted since the global financial crisis – corporate bond yields are currently higher than the S&P 500 free cash flow yield for only the second time since the Global Financial Crisis. By this measure, US equities now look relatively expensive compared to US bonds. In contrast, this measure has not swung as decisively in other developed markets like Japan and Europe where we sourced equity overweights in our portfolios at the start of 2022.
US corporate bonds have started to look attractive relative to equities
Source: BlackRock, Datastream as of 31 May 2022. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
The tightening of US financial conditions has also coincided with a deceleration in US corporate profitability. The plot below shows the after-tax profits for all US corporations, including both publicly listed and private firms. After soaring by nearly 50% post-COVID (in part thanks to large technology companies that disproportionately benefits from the stay-at-home economy), profits show some signs of slowing in the most recent quarters as consumption patterns shift and cost pressures weigh on earnings. In our view, forecasts for future earnings based on extrapolations of the trend over the last two years could potentially prove overly optimistic.
US corporate profits show some signs of slowing
Source: BlackRock, Bureau of Economic Analysis as of 30 April 2022
What does this mean for investors?
A common factor underpinning the year-to-date losses across financial assets has been the sharp tightening of monetary policy by the Fed. High inflation and wage growth are likely to keep these tight financial conditions intact as we head into the second half of the year. In our tactical multi-asset portfolios like the BlackRock Tactical Opportunities Fund, we look to capitalize on relative value opportunities across countries and have positioned for non-US developed equity markets to outperform. In our view, corporations in markets with less acute inflation pressures and accordingly less restrictive monetary policy stand to benefit in the current environment.
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