Positive real yields sting safe stocks

Good morning. Earnings season has passed its first hurdle — big bank earnings on Friday were fine (though we are still waiting on Goldman and Bank of America, tomorrow). Next hurdle: big tech, starting with Tesla and Netflix on Wednesday. But observers of the US economy will find much to think about in some smaller companies this week: the trucker JB Hunt, the grocer Albertsons, Snap-on tools, assorted regional banks. Let us know what you are watching and why: robert.armstrong@ft.com and ethan.wu@ft.com.

Staples stocks as bond substitutes 

Sometimes I overthink things. Last week I wrote about my puzzlement about the extremely poor performance of consumer staples stocks since May. Flight to safety in reverse? Rate sensitivity of staples demand? Diet drugs cutting demand for cheap calories? None of the explanations, even in combination, seem quite satisfactory. 

Several readers wrote to point out I had missed an obvious candidate: staples stocks are a bond substitute, and as bond yields have risen to attractive levels, substitutes are no longer necessary. This is particularly compelling given that underperformance of staples began at about the same time that bonds began to offer positive real yields, and has continued as real yields have risen further.  

This is more appealing than the other explanations. I think the reason that I didn’t think of it in the first place is that staples stocks have been expensive in recent years and, correspondingly, their dividend yields have not been particularly compelling. Back in May, when the staples sell-off began, yields for S&P 500 staples were about 2.5 per cent on average, only a bit better than the wider market. In the classic bond alternatives, utilities and real estate, yields were over 3 per cent and 4 per cent, respectively. 

What is a bond substitute, anyhow? It could be a source of yield — but also of safety, or diversification, or some combination thereof. The three are not the same.  

In the horrible year 2022, when stocks and Treasuries were positively correlated and both fell hard, staples may not have provided much yield, but they provided safety. And as soon as the stock/bond correlation reversed in the spring of 2023 (with stocks rising and bonds falling) that ended:

When real yields are significantly positive, there is less reason to own staples as a hedge against downward stock volatility. So if the era of zero or negative real Treasury yields are behind us, is the era of premium valuation for staples stocks over? 

Below are the price/earnings ratios of staples and the S&P over the past five years, which shows staples trading at a premium except in the rocket-like recovery of 2020-2021, when riskier, growthier stocks outperformed (a similar pattern emerged during the dot.com bubble). Those mid- and late-cycle staples premiums may be a thing of the past:

Monetary tightening and the supply side

Tight monetary policy hurts demand. What does it do to supply?

Economists’ traditional answer: not much. The conventional view is that monetary policy is a tool of demand management across the business cycle, with few to no lasting effects on supply. From the vantage point of a monetary policymaker, supply is set exogenously, influenced by such uncontrollable inputs as regulations, taxes and productivity. The view, articulated by Milton Friedman half a century ago, boils down to “potential output is independent of monetary policy”, as the economist Olivier Blanchard wrote in 2018.

One could look at this cycle and argue this seems about right. After a lag, historically fast monetary tightening is having its desired effect. Rising auto and credit card delinquencies weighing on sales for consumer staples are the most recent item in a list that includes depressed existing home sales, more corporate defaults and contracting profits. Meanwhile, supply has recovered from exogenous pandemic disruptions and appears largely unaffected by high rates. Official estimates of the US economy’s “potential” (ie, maximum sustainable GDP growth) suggest we will emerge from both the pandemic and the tightening cycle broadly unscathed:

But the view that monetary policy is about demand management, with few implications for supply, is coming under question. Some economists are wondering if monetary policy’s supply-side effects have gotten ignored.

In a paper presented at the Fed’s Jackson Hole conference in July, Yueran Ma and Kaspar Zimmermann argue that rate increases may hamper the supply side by reducing investment in innovation. This happens in two ways: through demand and through financing. By lowering end demand, tighter monetary policy makes it harder to find customers for new products, perhaps killing a project in the crib. And by raising the risk-free rate, tight policy reduces investors’ incentives to back riskier, cutting-edge products — the flip side of today’s popular “T-bill and chill” investment strategy.

Innovation investment is hard to measure, so the authors look at everything they can, including nationwide investment in intellectual property products, early- and late-stage VC deals and public companies’ quarterly R&D spending. Most interestingly, they look at how monetary policy affects patent filings for technologies classified as disruptive, based on whether the underlying tech is a frequent mention in companies’ earnings calls. Across all measures, the authors find that less is spent on innovation investment in the years after a 100bp increase in rates. The decline is especially pronounced for VC funding, which declines as much as 25 per cent within three years. Patenting in disruptive tech falls up to 9 per cent.

Ma and Zimmerman’s work points to one potential link between tightening and the supply side. By lowering innovation investment, long-term productivity drops, pushing output down. But does this idea match the empirical record? Another recent paper, published by three San Francisco Fed economists, looks at the relationship between tightening and long-run economic activity across the world since 1900. They find that tightening hurts growth over time by weighing on productivity and capital accumulation: 

The Fed economists argue this is best explained by rates throttling R&D investment and highlight a cruel asymmetry of monetary policy. While tightening depresses long-run GDP, monetary loosening has no corresponding benefit:

If these findings are clear enough, what they mean for the Fed is less straightforward. Yes, VC funding and public corporation R&D spending has slowed this cycle. But taking this to mean the Fed ought to go easy on rates ignores institutional constraints. No other official actor is tasked with price stability like the central bank is. 

Preston Mui, an economist at Employ America who has written an excellent blog post summarising this literature, argues that targeted fiscal policy to support innovation investment is what’s needed. Happily, this appears to be happening. As private sector R&D investment has fallen, the state has made up for it, and then some:

Mui points out that “a lot of the elevated government investment in R&D was Covid-related, such as health research expenditures, and then followed now by energy”. He expects the trend to continue as funds from the Chips Act and Inflation Reduction Act kick in.

Perhaps one lesson is that for all the understandable hand-wringing about high deficits, big fiscal has big upsides, too. (Ethan Wu)

One good read

Corporate diplomacy at Microsoft.

Source: Economy - ft.com