When the Prosperity Parade Goes Haywire: How Positive Real Returns Can Deal A Blow to Safe Stocks

Good day. Earnings season has cleared its first hurdle: Big bank results on Friday were strong (although we’re still waiting for Goldman and Bank of America tomorrow). The next hurdle: Big Tech, starting with Tesla and Netflix on Wednesday. But observers of the U.S. economy will find plenty to think about this week in some smaller companies: trucker JB Hunt, grocer Albertsons, Snap-on Tools and several regional banks. Let us know what you’re seeing and why: robert.armstrong@ft.com and ethan.wu@ft.com.

Commodity Stocks as Substitutes for Bonds

Sometimes I think about things too much. Last week I wrote about my bewilderment at the extremely poor performance of consumer staples stocks since May. Flight to safety upside down? Sensitivity to commodity demand rates? Do diet drugs reduce the demand for cheap calories? None of the explanations, even combined, seem entirely satisfactory.

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

This is more attractive than the other explanations. I think the reason I didn’t think about it in the first place is that commodity stocks have been expensive in recent years and, consequently, their dividend yields haven’t been particularly attractive. In May, when the commodity sell-off began, S&P 500 commodity returns were about 2.5 percent on average, only slightly better than the broader market. In the classic alternatives of bonds, utilities and real estate, returns exceeded 3 and 4 percent, respectively.

What is a bond substitute? It could be a source of return, but also security, diversification or some combination of both. The three are not the same.

In the horrible year of 2022, when stocks and Treasuries were positively correlated and both fell sharply, commodities may not have provided much return, but they did provide safety. And as soon as the correlation between stocks and bonds reversed in the spring of 2023 (with stocks rising and bonds falling), that ended:

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

Below are price/earnings ratios for commodities and the S&P over the past five years, showing that commodities are trading at a premium, except in the breakneck recovery of 2020-2021, when riskier stocks and those with higher growth performed better (a similar pattern emerged during the dot.com bubble). Those mid- and late-cycle commodity premiums may be a thing of the past:

Monetary tightening and the supply side

Tight monetary policy hurts demand. What do you do to supply?

The traditional answer from economists: not much. The conventional view is that monetary policy is a demand management tool throughout the business cycle, with little or no lasting effects on supply. From the point of view of a monetary policymaker, supply is set exogenously, influenced by factors as uncontrollable as regulations, taxes, and productivity. The view, expressed by Milton Friedman half a century ago, boils down to “potential output being independent of monetary policy,” as economist Olivier Blanchard put it. wrote in 2018.

One could look at this cycle and argue that this seems correct. After a delay, historically rapid monetary tightening is having the desired effect. Increase in late payments on cars and credit cards weighing on sales of consumer staples They are the latest item on a list that includes depressed existing home sales, more corporate defaults and hiring gains. Meanwhile, supply has recovered from exogenous pandemic shocks and appears largely unaffected by high rates. Official estimates of the “potential” of the US economy (that is, maximum sustainable GDP growth) suggest that we will emerge virtually unscathed from both the pandemic and the adjustment cycle:

But the view that monetary policy is about managing demand, with few implications for supply, is being challenged. Some economists wonder whether the supply-side effects of monetary policy have been ignored.

in a paper In a presentation presented at the Federal Reserve’s Jackson Hole conference in July, Yueran Ma and Kaspar Zimmermann argue that rate increases can hamper the supply side by reducing investment in innovation. This happens in two ways: through demand and through financing. By reducing final demand, tighter monetary policy makes it harder to find customers for new products, perhaps putting a project in cradle. 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 coin. “T-bill and relax” Investment strategy.

Investment in innovation is difficult to measure, so the authors look at everything they can, including domestic investment in intellectual property products, early- and late-stage venture capital deals, and quarterly R&D spending. of public companies. Most interestingly, they analyze how monetary policy affects patent applications for technologies classified as disruptive, depending on whether the underlying technology is a frequent mention in companies’ earnings calls. Across all measures, the authors find that less is spent on innovation investment in the years following a 100 basis point increase in rates. The drop is especially pronounced for venture capital funding, which declines by up to 25 percent in three years. Patents in disruptive technology fall to 9 percent.

Ma and Zimmerman’s work points to a potential link between tightening and the supply side. By reducing investment in innovation, long-term productivity falls, which reduces output. But does this idea match the empirical record? Other recent articlepublished by three economists from the San Francisco Federal Reserve, analyzes the relationship between adjustment and long-term economic activity around the world since 1900. They find that adjustment harms growth over time by affecting productivity and the accumulation of capital:

Federal Reserve economists argue that this is best explained by rates that strangle investment in R&D and highlight a cruel asymmetry of monetary policy. While tightening depresses GDP in the long run, monetary easing has no corresponding benefit:

If these findings are clear enough, what they mean for the Federal Reserve is less clear. Yes, venture capital funding and R&D spending by public corporations have slowed this cycle. But interpreting this to mean that the Fed should be lenient on rates ignores institutional constraints. No other official actor has the task of price stability like the central bank.

Preston Mui, an Employ America economist who has written a excellent blog post Summarizing this literature, he argues that what is needed is targeted fiscal policy to support investment in innovation. Fortunately, this seems to be happening. As private sector R&D investment has fallen, the state has compensated for it, and then some:

Mui points out that “much of the high government investment in R&D was related to Covid, such as spending on health research, and then energy has now followed.” He expects the trend to continue as the Chip Act and Inflation Reduction Act funds take effect.

Perhaps one lesson is that, for all the understandable cries about high deficits, big fiscal measures also have big advantages. (Ethan Wu)

a good read

Corporate diplomacy in microsoft.