Not investment advice.
The markets did the Fed’s job for them. This week, a spike in oil prices triggered a spike in bond yields, which now means the market is discounting a series of central bank rate hikes. All officials need to do is follow the path laid out for them, which is a series of hikes.
For stocks, this means the path to higher prices is via strong earnings because PEs won’t go up and may fall. Stocks with weak earnings might suffer some pain, while those at the center of the AI and energy dislocation might do OK, but less well than they normally would if the Fed was not tightening. Bonds have had a terrible year and the sum of slower stock price rises and falling bond prices is weaker asset returns, which is what normally happens when the central bank tightens.
Bond yields have two parts—the real yield and inflation compensation. Bond yields are going up in large part because real yields are going up, and real yields are going up because of the wars and a big productivity/capex shock. AI capex spending in the next year is around $1 trillion on the balance sheet and maybe another $800 billion off balance sheet. That is on top of big government deficits. The US is set to be on par with Brazil (though the actual US budget deficit now is smaller than the figures below, more like 6%).
Energy prices are mooning, which also hurts bonds.
Real yields, now at about 2.5%, drive the pricing of both stocks and bonds.
When real yields go up, PEs go down, which is what has happened this year. Stocks are up, but it’s all earnings driven.
The earnings are disproportionately driven by AI and energy/commodities.
How high can real yields go? Well, it was harder to measure that directly going back through time because the inflation-linked bond market was not in existence, but you can infer the yield as I did below. As I noted above, real yields got a lot higher.
To be sure, if the AI boom really does materialize, it is indeed possible to grow out of this, particularly if AI can somehow lower medical costs, which would reduce inflation and government outlays. We need a nominal growth rate that is much faster than the nominal interest rate to do it, which means a lot is riding on this productivity boom being a doozy. I’m hopeful it will live up to those expectations, but I am watching carefully to see if that is indeed true.
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