Stocks fell for the second consecutive session as long-term bond yields continue to rise in the wake of a U.S. rating downgrade from Fitch. As earnings season winds down, changes in interest rates will have outsized impact on the direction of equity prices.
The rating downgrade really didn’t say anything new. When Fitch detailed its decision, two points stood out. One was the consternation around efforts to increase the debt ceiling. While the debt ceiling laws are arcane and almost dysfunctional, few expected a U.S. default. Most importantly, most of the related movements in the bond market centered on very short-term maturities. Stocks were largely unaffected. The other point related to a build up of debt both in absolute numbers and as a percentage of GDP. A good point, but one well known by markets. Thus, the basis of the downgrade, while arguably valid, didn’t offer any new news, and over time will largely be ignored by markets, just as the downgrade the last time there was a debt ceiling crisis by Standard and Poor’s also had little impact.
The timing of the rating change was also a bit curious. Deficits aren’t suddenly accelerating and the debt ceiling crisis has been over for many weeks. Nonetheless, the media has tied it to the stock market’s decline this week. But is that valid? Short term rates have barely moved. All the movement has been at the long end of the curve where inflation and interest rates are crucial factors. That leads us to today’s pending employment report and next week’s CPI release. Both are expected to reinforce the conclusion that inflation is fading, the Fed is winning its battle, and that short-term rate increases are over or nearly done as far as the FOMC is concerned.
Markets want it both ways. They want ongoing growth and lower inflation. GDP growth in the second quarter was 2.4% and inflation is falling. Sounds like the market has it right, but is that the right conclusion? There are two ways it can be wrong. First, growth can disappear. We all know monetary policy works with a lag. In the fourth quarter of 2007, GDP grew by over 2%. We know what happened in 2008. Second, the Fed’s goal is to bring inflation down to 2% or lower. Markets today suggest long-term inflation is well anchored a little below 2.5%. Markets don’t want to quibble about a few tenths, at least not right now.
There are many who say the spike in inflation after the Covid pandemic set in was more related to supply chain problems than excessive demand. Now that supply chains are healing, inflation is coming down again. That may be true, but is all the hullabaloo just supply chain related? Before the pandemic, oil was $55-60 per barrel. Now it is around $80. Wages are rising at a 4%+ annual rate or more. There is a shortage of workers and a shortage of available homes for sale. Food is taking an increasing share of our budget. For a while collectively we have solved the problem by reaching into our pockets and spending all the money handed out during the pandemic.
Thus, maybe the bond market isn’t simply reacting to Fitch’s downgrade. Maybe it is saying that bringing inflation back to 2% isn’t going to be so easy.
The price of a bond reflects an expected rate of inflation over the life of the bond plus a premium to compensate the lender for risk taken. In recent years, that risk premium has been very low, often under 1%. At times, especially overseas, the risk premium was negative, meaning interest rates were even lower than the future expected rate of inflation. Economists argue about the causes, but the most obvious one was an overly expansive monetary policy. Prior to the Great Recession, the risk premium for bonds maturing 10 years out or longer was well over 2%. If I add 2% to current long-term inflation expectations, a 4.5% 10-year yield on Treasuries would seem logical. Currently the yield is close to 4.2%. The premium during times of neutral to restrictive monetary policy should be higher than when central banks are dropping money out of helicopters.
What happens if the 10-year goes to 4.5%? Stocks and bonds compete for the same dollars. Let me make a point to be absurd. For demonstration purposes, let’s assume investors view Treasuries as risk-free from a credit standpoint. Now, suppose I said that 10-year Treasuries would be available at a 10% rate. Over the long-term, stocks return 8-9%. Obviously, they are riskier than Treasuries. Thus, wouldn’t virtually everyone sell some stock to buy 10% bonds with no credit risk? Of course, they would. P/Es would come down. Conclusion: rising rates mean lower P/Es. Stock and bond prices work under the same laws of supply and demand as everything else. Thus, rising rates put downward pressure on stock prices.
For the past few months, as the stock market surged, bond rates stayed within a narrow range. Second quarter earnings fell, but not as much as anticipated. The Fed raised rates in July, but the promise of another rate increase in the fall faded, reinforcing the rally.
But now there are some storm clouds. Earnings season is winding down. As noted, oil prices are up. Higher gasoline prices serve as a tax on other forms of consumption. Wheat prices are rising again thanks to Russia’s attacks in the Black Sea. Home prices have stopped falling. Next week’s CPI report for July probably won’t reflect these changes fully, but the August report might.
As I have been noting, stocks aren’t cheap, while at the same time, earnings aren’t growing. Nothing suggests to me that earnings expectations need to be ratcheted up significantly. That means the near-term path for the stock market will be correlated to changes in the bond market. Getting inflation back toward 2% isn’t going to be as easy as recent data may suggest. Virtually no one is forecasting long-term bond yields higher than 4.25%. But does a return to 3.5% or lower make any sense when inflation expectations are near 2.5%? And what happens if those expectations increase, even a little bit? In 2009 the economy had a huge amount of slack. Today it has very little. This morning’s focus will be on the jobs market. Whatever the employment report says, it will be market moving. One always likes to see job growth, but too much of a good thing can be concerning.
Today, film director Greta Gerwig, the brains behind “Barbie” is 40. Meghan Markle is 42. Roger Clemens turns 61 while former President Barack Obama turns 62.
James M. Meyer, CFA 610-260-2220