by Jurrien Timmer, Director of Global Macro for Fidelity Management & Research Company
Bent Not Broken
Stress levels in the financial markets have subsided a bit as the conflict in the Middle East enters its 5th week. As the chart shows below, bonds and equities (and their vols) have moderated as the number of ships passing through the Strait of Hormuz is ticking up modestly (from 0 to 4). The “jaws” between geopolitics on the one hand and the private credit markets on the other continue to close. For the S&P 500, accelerating earnings have limited the drawdown to high single-digits rather than the 20% compression in the P/E ratio. The bull market is bent but not broken.
Curve math
Crude oil is now trading at $115 (as of Sunday night) while the forward curve has gotten even more backwardated. It’s unclear to me whether the backwardation is a manifestation of optimism over the Strait re-opening or the mechanics of the crude oil storage math.
YTD leaderboard
With month-end and quarter-end behind us, the S&P 500 was down 4.3% YTD (as of March 31). Only Bitcoin and large cap growth have done worse, at least for the cohort of asset classes that I follow. On top were commodities, followed by gold and managed futures. Bonds were in the middle of the pack.
Heatmap
The heatmap below shows that correlations between equities and bonds as well as between gold and bonds remains stable and positive. These assets all continue to trade in lockstep.
Oil shocks
Crude oil finished the week at $112 (WTI) and $109 (Brent), making the current oil shock almost a double.
Analogs
The analog chart below shows the major oil events since the 1970’s. The green line (1990 Gulf War) remains the best-case scenario, namely a short war that produces a full roundtrip in crude oil.
Even by 1990 standards, the stock market has produced only a modest drawdown (9.8%), considering the magnitude of the events taking place. Unlike 1990, earnings are doing a lot of heavy lifting to keep prices from falling further.
Equities
The S&P 500 index has continued to fluctuate in an elevated range (4-5% per week), as markets try to find their footing amid the conflicting headlines. The trailing P/E ratio is now 23.3x and the implied equity risk premium is 4.4%
Cyclical bull
The cyclical bull market, which started 45 months ago, remains intact for now. Bent not broken.
Earnings
The forward earnings estimate has been growing at a robust 17% annual rate and the momentum has thus far not been affected by the headlines.
This strength has been enabling the cycle to become more balanced between valuation and earnings. As of March, the attribution of the market’s gain is about evenly split between P/E-expansion and earnings growth. That’s a far cry from a year ago when it was mostly valuations pulling prices higher.
Not extended
Taking a longer look, we can see below that the S&P 500 equal-weighted index is right on its rising trendline, while the forward P/E ratio is at 18.2x. It’s hard to accuse the market of being over-extended, at least in equal-weighted terms.
Mag 7
Even the Mag 7 have come way down in terms of valuation, following their 17% drawdown since last October’s high. The cohort is now trading at a modest 25x forward P/E.
Rates
On the rate side, the 10-year yield continues to push up against the 4.5% “red zone” (above which “nothing good” happens), driven by real rates and the term premium. Credit spreads moderated a bit last week, as did the drawdowns in the private credit space (except for Blue Owl, which made a new low).
Continuation pattern
If we invert the 10-year bond yield we get a “P/E” ratio for bonds. The chart below shows that since the 2022 rate reset, the bond P/E has been stuck in a tight triangle. That triangle could be a base, but history shows that triangles more often than not resolve themselves in the direction of the prevailing trend. If so, we might be entering the danger zone above 4.5% at some point this year.
Secular trend
The chart below shows that the secular bull market remains firmly in place, with a clear series of new highs and new lows.
CAPE model
However, the CAPE model (which holds that today’s 10-year P/E ratio determines the 10-year forward return) suggests that a secular peak may not be that far away. As scary as it sounds, all the CAPE model is predicting is that the 10-year CAGR will moderate from 15% to somewhere in the single digits.
Secular analogs
Confirming what the CAPE model suggests, the previous two secular bull markets (1949-1968 and 1982-2000) also suggest that future returns will not be as robust as the last decade-plus.
Commodities > equities
Another yellow flag is coming from commodities in general and gold in particular. Both have been outperforming the stock market as of late, which tends to be a feature of secular bear markets rather than secular bull markets. It’s just one data point but perhaps part of an evolving mosaic.
CAPEX
For now, the bull is alive both cyclically and secularly, with earnings, capex, and margins driving both price and valuations higher. Below we see that capex as a percentage of revenues continues to make new multi-decade highs.
Margins
Margins are also making new highs (now at 15%), which goes a long way to explain the elevated valuation backdrop.
Bubble watch
Just six months ago the question of the day was whether the AI boom was turning into a bubble. Fortunately that did not happen, or the current drawdown would likely have been much bigger. Instead of the AI leaders heading into the bubble stratosphere (as CSCO did in 2000), today we see the opposite. Investors are asking the tough questions (which they don’t do in bubbles).
Beyond the 60/40
With equities and bonds once again positively correlated, the purest diversifier have been commodities.
Correlation matrix
The positive stocks/bonds correlation highlights the need to think beyond the 60/40 model in order to find other sources of uncorrelated returns. Fortunately we have those in the form of commodities and alts.
Commodity bull market
Commodities (per the Bloomberg Commodity Spot index below) are at new highs, driven largely but not exclusively by energy. Some 83% of the components in the BCOMSP are in uptrends.
Vol tax
The problem with commodities is that over the very long term they have tended to only produce the inflation rate (3%) while being as volatile as emerging market equities. The resulting “volatility tax” is very high relative to its return. Commodites have their place, cyclically and secularly (including now), but not as an evergreen strategic asset.
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.Copyright © Fidelity Investments
