Stocks continued to move lower yesterday. For a change, the catalyst wasn’t falling bond prices. Bonds remained steady throughout the session. Yesterday’s news was gut-wrenchingly bad earnings reports from Macy’s and Dick’s Sporting Goods, plus more credit rating downgrades from regional banks. The bad results from the two big retailers sent everything consumer-related lower. Given that the consumer represents close to 70% of GDP, that news meant a lot of hurt. About the only places to hide yesterday were travel-related stocks and data centers benefiting from increased demand for capacity related to AI.
For months, investors and economists have been waiting for the impact of higher interest rates to hit the economy. It appears that finally may be happening. Existing home sales fell again in July and are now 16% below year earlier levels. Mortgage demand for new home purchases is at the lowest level in over two decades. Despite reduced demand, lack of quality inventory has kept prices high. High prices and high mortgage rates combine to reduce activity causing young families to defer buying decisions and empty nesters to stay in place, unable to get good prices for homes that haven’t been remodeled in a generation.
All this serves as a backdrop to the Federal Reserve’s annual Jackson Hole retreat. Until recently, persistently strong data has had some FOMC members calling for higher rates. Others, recognizing the lag effect of rate increases, and the huge amount of excess Covid government handouts still sloshing around, choose to pause and wait. Inflation is coming down but remains well above 2% targets. While a 2% target is deemed too aggressive in today’s world for some, it isn’t. Look at the chart below.
Source: EvercoreISI
Clearly, there is a relationship between nominal GDP and the yield on 10-year Treasuries. Nominal GDP growth is the sum of the volume growth of goods and services plus the expected long-term pace of inflation. If you look closely at the graph, from 1980 until just after 2000, the red line, representing yield, was slightly higher than GDP growth rates. But after 2001, the opposite happened. Bond yields were lower. Said differently, bond returns failed to provide adequate real returns to investors post-2000. Why? In simple terms, easy money. Central bank policy of easy money inflated the value of assets, all assets, including both stocks and bonds. More demand for bonds meant higher prices and lower rates. The two curves remained close to each other, but the overwhelming supply of money nudged the 10-year yield below what neutral policy would lead one to believe. For much of the time, bonds didn’t even cover inflation. Real returns were negative. That kept valuations high, while at the same time, distorted investment spending. Free money can lead to stupid decisions.
Unless Treasury and the Fed want to return to an extended period of easy money, the two lines in the future should overlap more closely. If one wanted a monetary policy centered on 3% inflation, that would suggest a corresponding yield of close to 5%. If you hold real growth constant and simply accept higher inflation, the end result without excessive central bank interference is higher interest rates.
Remember this. When you buy a 10-year bond, you will be repaid 10 years from now in today’s dollars. Spend $1,000 today and you get $1,000 back in 10-years. But the purchasing power of that $1,000 10-years from now will be less than today. If inflation is 3% rather than 2% over the decade, what you get back in real terms is much less. To compensate, the interim income (bond interest) you will receive will have to be greater. Thus, accepting higher inflation deflates your savings while increasing interest rates. Those who want the Fed to start cutting rates when inflation gets to 3% simply want the lid taken off the cookie jar for some expected near-term gain. But doing so would be a long-term disaster. Fortunately, Powell sees this. Don’t look for any talk Friday about changing long-term inflation targets. He may tolerate some extra time to get there, but the target won’t be changed.
Again, looking back at the chart, one can also see that 4% or so is much closer to the norm of the past 5+ decades, than rates have been over the past 15 years. 2% is a realistic growth target combining demographic growth of a bit over 0.5% with average productivity gains of about 1.5%. Nothing Congress or the Fed does is going to change population growth short of massive immigration reform, a very unrealistic expectation. As for productivity, that is also outside the purview of Congress or the White House. Indeed, one can argue rather effectively that Washington interference is more likely to hurt rather than help.
So where does that leave us?
1. Growth is slowing. The Atlanta Fed says GDP growth in Q3 is running at a rate over 5%. Macy’s and Dick’s Sporting Goods don’t agree. There still may be some growth, but 2% or even less would be a more reasonable expectation near-term.
2. Interest rates reflect a movement toward normalization. Short rates remain elevated until the Fed seriously starts considering rate cuts. The only way that will happen is if there is a recession or inflation moves below 3% and stays there for a few months. Markets are still pricing in three 25-basis point rate cuts by next September. I only see that happening if there is a recession.
3. Equity forward P/E ratios are out of synch with bond prices. One of four things (or a combination) has to happen to align them.
a. Earnings can accelerate, only possible if the economy continues growing
b. Inflation can fall into targeted ranges sending bond yields lower
c. A recession occurs
d. Stock prices fall
The odds of recession remain elevated. When companies like Macy’s and Dick’s start to feel the storm winds blow, they lay off workers. So far this cycle, that hasn’t happened. It’s starting. Whether it evolves into a full-fledged recession or not is a close call. But to defeat inflation and keep it from returning, there is a necessity to create some economic slack. Weak retail sales aren’t the only deteriorating economic factor. Our world is awash with excess office space and soon excess apartment capacity. Used car prices are falling. So are domestic airfares. As noted, demand for mortgages to buy homes is at a 2+ decade low. There is still residual strength from travel, healthcare and technology. Infrastructure spending should escalate as more Federally-funded projects are approved. Next year is an election year. Whenever politicians are able to hand out checks to entice voters, they will.
No one is looking for a significant recession. But no one was looking for 4.3% 10-year bond yields either. Economies don’t slide slowly into recession. Rather, consumers feel stress, stop spending, and the rest cascades. I have noted the seasonal weakness that often occurs from August to mid-October in the stock market. That’s the bad news. The good news is that late October through year end is normally a good time for equities. Some pause and a pricing reset is in order. I wouldn’t be surprised if any correction is somewhat worse than traders are looking for at the moment. Despite a weak August, traders are still complacent. Volatility indices are near multi-year lows. For a correction to be substantive, it must evoke a bit of fear. But the long-term picture is fine. A short-term realignment of valuations just might be the perfect medicine for a bright future.
Today, actress Shelley Long of “Cheers” is 74. Barbara Eden turns 92.
James M. Meyer, CFA 610-260-2220