Debt, deficits, and delusion—how markets may be misreading risk after Moody’s move.
KEY TAKEAWAYS
MY HOT TAKES
Prestidigitation. It’s actually a real word. Though I have heard it many times, I decided to look it up and it means sleight of hand. It’s often used to describe the work of illusionists. Presto!
I want to leave you with one final word on yesterday’s Moody’s downgrade of US foreign debt. I played it down in my blog post yesterday as a tempest in a teapot. It was the dominant theme in yesterday’s financial news cycle. It was a busy day and most of us were keeping one eye on the tape, another eye on the TV, and another eye on the markets. I know that’s three eyes–it’s not easy to be a portfolio manager.
That eye following the markets witnessed what might have been challenged as witchcraft in another era. One of the world’s most prominent ratings agencies, feared by one and all, downgraded the credit rating of the US. It could have been an “end of days” event, but alas it was not. It was the Gen-Z / Millennial equivalent of posting a hot pic on Instagram which got no likes.
Really, what gives? Let me remind you that the reason for the downgrade was the US’s oversized and growing deficit and debt pile. Did you know that the US has a $2 trillion deficit and monstrous amount of debt outstanding? Of course, you do, even my dog walker knows it.
Standard and Poor’s downgraded US debt in 2011 and Fitch Ratings followed in 2023. Late in last year’s Presidential election cycle, it became clear to markets that both parties were offering up so much stimulus that, despite the winner, US debt would be materially impacted.
Longer-maturity Treasury yields began to climb despite the Fed’s cutting interest rates. This was confusing to some, but it was quite clear to bond traders who knew that increased supply of Treasuries needed to fund the deficit meant lower prices and higher yields. So, last Friday’s post-market pronouncement by Moody’s was received by the market with little reaction. Welcome to the club, Moody’s.
Even though the market’s muted response was expected, it does not mean that there will be no implications for the US swelling debt pile. There will be a cost, it just may not show up within the confines of a trading session. Stay tuned.
Also floating around yesterday was this arcane thing known as the “Fed Model.” It debuted in a 1997 Fed report which asserted that there is an equilibrium between stock market earnings yield and US Treasury 10-year Note yields. If S&P 500 earnings yield is greater than Treasury yields, stocks would be considered undervalued. Earnings yield is the inverse of the popular P/E ratio and is literally calculated by dividing earnings by price.
Now I know that earnings yield is an odd concept because investors don’t technically receive those earnings but humor me for a moment. Let’s just say that there is some value to earnings yield. Currently, the S&P 500 forward P/E 20, which means that earnings yield is 5% (inverse, 1/20, it’s just math, silly). 10-year yields are at 4.45%, therefore the Fed model would tell us that stocks are undervalued, but interpreted another way, it can also mean that 10-year bond yields are too low!
10-year yields are influenced by many things. Of course, there are current economic conditions such as inflation expectations that have a big influence on yields. Demand is always a big influence, and demand for treasuries rise and fall based on risk in the equity markets as investors often run to Treasuries for safety when equities are under pressure. There is, of course, supply, as we have learned since last Fall. Though it is not often discussed, credit risk is crucial. Higher risks should come with higher risk premiums, as in yield. Investors need to be compensated for taking on greater risk.
Now, Moody’s rating downgrade should, in theory, put upward pressure on yields. Though this was not evident in yesterday’s trading day. Is it possible that bond traders got it wrong and should have sold off yesterday? Well, if you have been following all this voodoo math, you might have already come to the conclusion that perhaps stocks are undervalued. Before you go and use this as your bull battle cry, there are some caveats.
First of all, stocks should have a risk premium over bonds! If you agree, then as stocks get more volatile (as they have been), the risk premium should be greater, but according to the Fed model, the wider discrepancy means stocks are even more undervalued. Oh, and I should tell you that empirical tests are inconclusive on whether or not the model produces extra-market returns.
Now that we are done with that diversion, let’s get back to reality. Equities have had a bit of a positive run in recent days. Some of it may be justified as progress is being made in trade developments and on tax legislation. Earnings season is in its final days and has been better than expected. “Hard” economic numbers have not yet thrown any tariff-related curveballs, but the “soft” economic numbers suggest pain ahead.
Are equity traders ignoring the obvious pending risks and being driven by the FOMO trade? It is likely that markets are not correctly factoring in the true costs of tariffs that have yet to be witnessed. That is to say that equity risk premia are too small. Put another way, earnings yields may be too low given the current level of risk. One way to make earnings yields go up is to lower prices. It's just math, silly. Are you properly confused yet? Be smart and stay alert. Don’t get fooled by illusion in these tricky markets.
YESTERDAY’S MARKET’S
Stocks gained yesterday after–but not in response to–Moody’s downgraded US debt to its second highest rating, stymying logic-thinking investors. Stocks shrugged off the Moody’s news in favor of the inching forward tax bill and lots of smiles in trade negotiations. Bonds also posted a muted response giving stocks the “all clear!”
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