The 3rd Quarter ended with a pullback in US equity markets as interest rates continued their march higher. U.S. 10-year yields are at 16-year highs, and we do not believe the process is over. We see investors demanding more compensation for bond risk and we are still underweighting long-duration assets. We have been underweighting long-term U.S. Treasuries since late 2020 as we foresaw the regime change heralding higher rates. Our view from last quarter is largely unchanged, interest rates are moving higher, largely a result of supply pressures in the bond market, not inflation. These higher rates are affecting the equity market, as equities compete with bonds. For the first time in decades, bond rates are becoming attractive. We see few signs of an immediate recession as the US economy continues to surprise to the upside with strong consumer demand and strong employment. Additionally, there is a strong seasonal tendency for the equity market to do well in the 4th quarter before an election year.
Investors are largely pessimistic and are not buying into bullish narratives, which may continue to cause the market to climb a wall of worry. There are many conflicting signs, and we would not be surprised to see a range bound equities market (from current levels) until next year. The equity market is at a critical level as we write this piece, and current geo-political events are adding pressure to a still solid economic backdrop. We are defensive and currently have about 20% cash in our equity portfolios, as the conflict between higher rates, good economic data and the uncertainty of a recession is overhanging all markets. We want to highlight the most important takeaway that we have for the current quarter. Bond rates are becoming attractive, and we will be making significant changes in our bond portfolio over the coming months. Higher for longer in rates is the new market mantra and may eventually affect equity markets.
The Economy, Federal Reserve Monetary Policy, and Interest Rates
The US economy continues to move forward. Higher rates are not having the constraining effect most pundits were looking for. Fiscal stimulus and strong corporate balance sheets are dulling the effect of higher rates. Are these factors delaying the “inevitable” recession? That chart below shows that it is quite normal for the effects of an inverted yield curve coming from the Fed raising rates on the short end of the yield curve:
Source: EPB Research
Is there a chance that the economy has already bottomed out, and the Fed has achieved the mythic, “soft landing”? Our answer is: we will see. There is always a chance that a soft landing has occurred, and for now, the data supports this notion. We must give the benefit of the doubt to this possibility, with a watchful eye on any weakness if it does occur.
Equities: Earnings, Valuation, and Sentiment
It is important to note that the rally in stocks this year has been very, very narrow. The largest 7 stocks in the S&P 500 (S&P 7) are up 55% and the other 493 stocks are up less than 1%. Returns are also negligible for Mid, Small, and Microcap stocks this year.
Source: Apollo Investments
Earnings season has started as we write this piece, and the consensus is for earnings to move higher by a modest amount, avoiding a recession. We see no reason that this will not be the case for this quarter, and probably for the 4th, however next year may be an entirely different scenario. The real cause for concern, looking ahead, is that equity valuations compared to bonds are becoming less attractive.
The chart below shows that equity earnings yield compared to T-bills are basically the same. At the beginning of the bull market that began in 2009 after the GFC (Global Financial Crisis), equity yields were 9% higher than T-Bill yields. In our view, even if stocks continue to grind higher in a soft landing, stocks will still be relatively unattractive compared to bonds.
This should be a governor on how high the market may go later this year and next. But we still see rampant pessimism in the market, and this may, in the short term, have a positive effect on the market as pessimistic investors “give up” on cash and chase the market higher. Together, we have a market that seems to be climbing a wall of worry, but the ceiling is likely not far above due to equity valuations!
The seasonal tendency for the market to move higher in the near term adds to the potential for a grind higher within an environment of valuations that are unattractive. The result may be a lot of moves up and down in the coming months!
Source: Sentiment Trader
Our primary focus now is interest rates. We have been patiently waiting for interest rates to reach attractive levels for investors. Ever since the GFC, the Fed has artificially held rates low by increasing their balance sheet. They kept buying bonds to keep yields down and their balance sheet has more than quadrupled. The Fed is now actively reducing their balance sheet by selling bonds.
The U.S. budget deficit continues to expand and has resulted in further bond issuance by the Treasury. We also have evidence that foreign investors, that were formally buyers of our debt, are now sellers. All these events affect the yield curve’s long end.
We see about equal odds that Treasury yields will swing both up and down from current levels. In other words, we see two-way volatility ahead. The Fed is likely nearing the end of the fastest hiking cycle since the 1980s, and we now see policymakers shifting to assessing financial conditions. Fed officials said last week that tightening financial conditions due to surging long-term yields are likely doing some of the Fed’s work for it, however, we do not think that long-term yields have hit their relative high point. They will eventually resume their march higher as term premium gradually rises to account for greater macro volatility, persistent inflation plus large fiscal deficits and debt issuance. In the near term, inflation is easing as pandemic mismatches unwind from consumers shifting spending back to services from goods. We see inflationary pressures on a rollercoaster ride beyond the near term as an aging population shrinks the workforce, fueling wages and overall inflation. That backdrop begs the question: What will be the neutral policy rate that neither stimulates nor slows activity?
However, while we expect more rate volatility, we do believe that rates are approaching attractive investable levels. Long term investment grade corporates are yielding 6% or higher, and long-term Munis are yielding 3.50% – 4.50% which translates to taxable equivalent yields of 5.4% – 7% at the 35% tax bracket. Preferred stocks are yielding almost 7%.
We do not expect to rush into any of these areas, but we believe it is time to begin layering exposure to long-duration bonds around current levels. This is exciting news for investors who have been penalized with low rates for decades now. You can also understand why stocks now have competition from bonds!
Market narratives have been in flux all year: from recession and sharp rate cuts earlier in the year to soft landing hopes over the summer to more recently – a higher-for-longer rates backdrop. We think the volatility in long-term yields will persist, even as central banks have likely reached peak policy rates. Fed comments this week that higher longer-term yields were doing the policy tightening work for them helped confirm this. However, a renewed surge in U.S. CPI (Consumer Price Index), strong employment and consumer spending reinforced why we think the Fed is on the fence for now. Within all these conflicting signs on the economy, and rates, we are starting to see relative value in fixed income for the first time since 2007. While near term volatility in rates will likely persist, we are starting to believe that fixed income will be an attractive asset class over the next few years.
The move down in the market over the last few months has left the market oversold. It is possible that the market could climb a wall of worry and bottom if positive seasonality factors and oversold conditions occur. However, we are concerned about the longer-term fundamentals of the economy and rich equity valuations. We are in a defensive posture in equities (20% cash) and are watching closely for signs to see if positive seasonal influences, that usually occur in the 4th Quarter, can overcome the current geo-political pressure overhanging the markets. Most analysts are looking for 8-11% earnings growth in 2024, it remains to be seen if that will be true. We will be quick to reduce equity risk, and add fixed income duration, if these rosy earnings estimates do not materialize.
Our goal is to be appropriately positioned should the rally continue, but we will be ready to reposition more conservatively if obvious signs of a downtrend evolve.