Stocks rose Friday offsetting Thursday’s losses after Fed Chair Jerome Powell’s much anticipated speech. While Powell spoke in firm tones about the Fed’s resolve to beat inflation, he didn’t say anything new. While November futures suggest the odds of another rate increase in November is quite possible, reality says November is so far off that no one knows. Any guess is just that, a guess.
Look at the chart below. It shows the yield on 10-year TIPS bonds. Since the return on TIPS bonds is the yield you see in the chart plus inflation, it represents the real cost of 10-year money. As you can see, returns were negative from the beginning of the pandemic until a time in 2022 shortly after the Fed began to raise the Federal Funds rate. While 2% seems high today, almost three percentage points higher than what they were in 2020, they are not particularly high historically. In fact, even if you go back further before the dates represented at the beginning of the chart, 2% looks pretty normal. The negative real rates post-pandemic were tied to very easy monetary policy plus all the fiscal handouts we note continuously.
Now look at the next chart.
If real rates are rising, as is clear from the prior chart, then logic would suggest that P/E ratios shouldn’t be elevated. But they are. Is that rational or not? On the side of rational, one could argue that future growth rates, beyond the current period of tight money, will be higher than before. Or, one could argue that 2% real rates are excessively high. Both are possible. Neither is likely. For growth to sustain at a higher rate than experienced in the recent past, either population growth has to increase noticeably (unlikely), or productivity has to be significantly higher than long term trends. While one could argue that the advantages of generative artificial intelligence could boost growth, that is conjecture today with no existing evidence to support that thesis.
Are for real rates possibly being excessively high, there are few moments in good economic times suggesting lower real rates without significantly easy monetary policy or excessive fiscal spending. While there are many, including ourselves, who have howled that rising deficits have a long-term cost, the fact that debt service is fast approaching what government spends on defense and Medicare, suggests the rise cannot be ignored forever. Deficits this year and next are expected to be $1.6 trillion or higher. At the same time, the Federal Reserve is reducing its balance sheet by $1 trillion per year. Money supply is contracting at a commensurate pace. Progressives have been promoting an economic policy suggesting spending could be virtually unlimited as long as interest rates remained near zero. But that flawed concept is now undressed. Excessive monetary policy and a swollen Federal budget created both inflation and higher interest rates. Debt service comes first. If the government can’t service its debt, no one will lend it money. Thus, debt service comes before even defense and Medicare. If entitlements are allowed to grow by close to $2 trillion per year, what’s left to fund everything else? For decades, Presidents, Republican and Democrat, have punted, leaving the decision to a successor. I doubt the issue can be ignored beyond the current administration.
The stock market doesn’t care about government spending per se. But it does care about interest rates and P/E ratios. If real rates simply normalize around current levels, and inflation can be reduced to the 2% target, 10-year Treasuries should yield close to what they yield today. The risk to rates is that they rise further simply because of the immense amount of new debt Treasury must issue in the months ahead. That means 18-20x P/E ratios are unsustainable. It also supports why I am apprehensive over the next few months as growth slows.
A 10% correction would do wonders for this market. It would balance equity and bond prices and produce bargains for equity investors. It isn’t to be feared. On the other hand, short-term euphoria would feel good, but would create greater distortions between valuations of stocks and bonds. That would only delay the inevitable.
Today Shania Twain is 58. Scott Hamilton is 65. Artist and activist Ai Weiwei turns 66.
James M. Meyer, CFA 610-260-2220