Apple# reported solid earnings with revenues that were in-line with expectations, but its guidance suggests a relatively weak outlook for the December quarter. Concerns about demand for Apple products in China remains an issue, but its Services business helped the company report record margins. Apple’s earnings report is consistent with most other corporate reports this quarter. Companies are seeing stable conditions with easing inflationary pressures, but generally cautious outlooks.
Bond traders are now seeing the yield curve flatten. The difference between 2 and 10-year US Treasury yields has narrowed to -0.31% from the more than -1% inversion witnessed this past summer (See chart below). Most of the flattening has come from the 10-year yield rising. Recently, some of the best macroeconomic minds on Wall Street, including Stanley Druckenmiller and Jefferey Gundlach have suggested we have entered a new era of interest rates, now that sovereign debt levels are at historic highs relative to GDP, with deficits projected to worsen. Demographic trends will cause entitlement spending to accelerate at a time when interest expense on the debt reaches catastrophic levels.
So, how do investors adjust to this new paradigm? First, we acknowledge that certain fixed income securities are now a good alternative for risk averse investors. A couple of years ago, investors had to accept a near 0% return on their investment if they were most interested in protecting their principal. This 0% return alternative forced many investors to increase their exposure to riskier assets such as equities, real estate, etc. Today, the difference between expected returns for stocks and bonds is much narrower. For instance, a 2-year US Treasury bond yields approximately 4.8% as compared to long-term stock market return expectations of 7-8%. So, the difference has shrunk from almost 8% to about 3%. Thus, investors may want to consider reversing the overweight equity allocation that has naturally evolved since the Fed embarked on its quantitative easing experiment.
The problem for the Fed is that it may have exhausted its ability to print money now that we have experienced inflation. According to the Congressional Budget Office, fiscal deficits will continue to grow in the years ahead, which possibly presents inflationary pressure that will challenge the Fed to maintain price stability. If interest rates stay “higher for longer” as many expect, it will be natural for economic growth to slow. If we actually do enter a recession, it is not clear that the Fed will be able to react the same way it has over the past few decades with aggressive rate cuts and money printing programs, in part because of the already high debt levels (See Chart below).
Today’s payroll report listed 150,000 new jobs which was below the consensus estimate for 180,000. Moreover, September’s report was revised downward from 336,000 to 297,000. Unemployment ticked up to 3.9% from last month’s 3.8% as labor force participation declined to 62.7%. Other metrics such as average hourly earnings and average hours worked also fell slightly short of expectations. The near-term reaction from the stock market is positive, as this will provide more support for pausing rate hikes. However, a continued softening of economic data may not be so good for corporate profits in the intermediate term if these trends persist.
The S&P 500 is now up roughly 13% YTD, yet the equal weighted S&P 500 is now flat for the year. As is widely reported, almost all of the gains in the S&P 500 have been derived from the big tech stocks. These big tech stocks (i.e., Apple, Microsoft#, Google#, etc.) have seen their Price/Earnings multiples expand at much faster rates than their profits have grown. If the economy does slow while yields on long-term Treasuries remain high because of our fiscal and monetary challenges, one has to question the room for additional price appreciation of the large tech stocks, even if we do get the traditional year-end rally.
We are living in a period of great economic uncertainty. We don’t know which way the market will trade in the coming months. There will be opportunities to find individual businesses at attractive prices. But it may be wise to reevaluate your risk tolerance and asset allocation now that interest rates have risen and the opportunity cost to owning risk assets has become more expensive relative to holding safer assets. Managing risk is best executed before the surprise event occurs.
Vogue Magazine’s Anna Wintour turns 74 today. Actress and Comedienne Roseanne Barr is 71 today and Dolph Lundgren, (Ivan Drago in the Rocky IV movie) turns 66.