Last week, we argued that the "more positive" news about inflation in the US would reactivate trading based on a "policy pivot," on the understanding that lower interest rate pressures mean less pressure on valuations at a time when corporate visibility has been somewhat questioned after the Q3 2022 results, with further downward revisions to expected earnings for 2023 (see HERE). 

We also reaffirm our projections that US equities were already approaching fair value levels again, which could be exaggerated, of course, but limits the potential for further recovery, given that both absolute and relative valuations compared to bonds are not particularly attractive.

The S&P 500 trades at 17.3x future earnings (+1DS above its long-term averages), while the premium offered by stocks relative to bonds has fallen to 200 bp, 100 bp below its long-term averages and the lowest level in 15 years.

Equity valuations, both absolute and relative to bonds, are not particularly attractive.

The current recovery, as in the July-August period, is driven by hopes that inflation in the US has "peaked" and the belief that the Federal Reserve will soon share this diagnosis. Previous experience has shown this to be a good opportunity to sell and reassess risk exposure, and while we recognize the progress made in terms of monetary tightening and lower inflationary pressures on the margin, we cannot rule out history repeating itself.

That said, where we do see things starting to look more attractive is in the bond market. IG debt in the US currently offers a rate of 5.5% (it reached 6.0% just a few weeks ago), the highest level in 15 years, which, if adjusted for expected medium-term inflation, results in a real rate of 3.0%.

IG debt in the US currently offers a rate of 5.5% (it reached 6.0% just a few weeks ago), the highest level in 15 years, which, if adjusted for expected inflation, results in a real rate of 3.0%.

Look at what happens when you compare this with the implied yield offered by stocks today. It's practically the same yield! In other words, the spread between the implied yield offered by stocks (the inverse of the P/E ratio) and the yield offered by IG debt is practically zero, the lowest level since before the financial crisis. In the deflationary world prior to the pandemic, stocks had virtually no competition, but "today, people have started to catch up with them." and while stocks have a relative advantage over bonds in a more inflationary environment, as inflationary pressures begin to moderate, an intermediate step in risk-taking should be made via investment-grade fixed income, especially for moderate investment profiles.

The spread between the implied yield offered by equities (the inverse of the P/E ratio) and the yield offered by IG debt is practically zero, the lowest level since before the financial crisis.

Humberto Mora

Gerente de Inversiones Finanzas y Negocios Corredora de Bolsa