Relief or rationality?

The VIX fell by one third, high yield spreads fell by some 45-55 basis points, and – indeed – stock markets rallied.

The rally was more pronounced in the US, with the S&P 500 returning an impressive 10.5% – its strongest month since 2020. But this was a global phenomenon. Even in still energy-starved Europe, the STOXX Europe 600 rose by 5.5%. The sole exception this month was Norway, with the Oslo Børs benchmark index falling by 2.4%. This, of course, was mostly due to the high energy content in this index.

The very best performance was to be had in growth stocks. The MSCI World Growth Index rose by 11.7%, almost twice as much as its value sibling, and the Nasdaq Composite by a full 15.3%. As these indices typically contain stocks with a high implied duration (they have a larger share of their imputed value far into the future), one may be surprised to note that interest rates did not fall. On the contrary, they were flat or slightly higher. The yield curve did not change, either.

So … why did the most interest-sensitive stocks lead the pack?

The perhaps surprising answer is that interest rates did not go high enough. Despite the ceasefire, it became evident that energy prices would stay higher for a longer time than initially envisioned, meaning inflation projections had to be revised. In the US, 10-year forward market-implied inflation rates rose from 2.30% to 2.46%, and in the Euro area, they jumped from 2.14% to 2.57%. As expected inflation rose more than nominal yields, real rates in fact fell. The yield on US 10-year TIPS (Treasury Inflation-Protected Securities) fell from 2.0% to 1.9%.

In this context, the April rally was driven by lower real rates, not so much rejoicing at the news from the Strait of Hormuz. Investors apparently believed that the higher inflation would not be fully countered by higher nominal rates. Now, lower real rates often coincide with expectations of weaker growth, not exuberance. If we are seeing permanently higher energy prices, it will impact not only inflation but of course the real economy. This is the not so sunny angle.

On the other hand, unusually sharp stock market appreciation is hardly a harbinger of worse times ahead. And I’d like to add that 12 months forward estimates for the S&P 500 rose by more than 4%. That certainly provides some foundation for the appreciation, the rest of course driven by multiple expansion supported by the lower real rates.

On balance, maybe the message was simply one of returning to something resembling normality, a not very unusual turn of events obscured by particulars? After all, that is, well, what normally happens. The market is simply full of surprises that shouldn’t really be that surprising. In the end, rationality reigns.

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