September was the worst month of the year for equities. The NASDAQ was down 4%, the S&P 500 down close to 3.5% while the Dow fell 2.4%. There is little reason to search for the cause beyond one number. The yield on the 10-year Treasury rose from 3.85% to over 4.5%. This morning it is over 4.6%.
You can’t blame September on the economy, at least not directly. The U.S. continued to add jobs and GDP continued to grow. Consumers still have not used up their excess savings built during the pandemic. While there are signs that growth is slowing, it is still in positive territory. This despite a recent 30% spike in oil prices. Inflation continues to work lower but at a slow pace. The rise in oil prices, if sustained, will start to creep into core inflation numbers. If that happens, look for the Fed to keep raising rates. Under present policy, the Fed plans to take 2-3 years for inflation to return to its 2% target. To do that, the Fed will have to keep monetary policy tighter than normal for an extended period. Thus, while short-term Treasury yields have been above 5% for some time, the “higher for longer” approach has helped to push rates higher all along the curve. It is now quite possible to buy investment grade debt out to 10 years or longer with safe yields to maturity of 5% or more. Given the relative riskier nature of equities, what return is needed to entice money away from bonds?
For equities, the risk level is imbedded in the P/E ratio. The lower the P/E, the lower the risk. Today, stocks trade, on average, at over 18 times earnings. With rates rising at a rapid pace, one can make the case that stocks are more expensive today than they were a month ago based on the movement in interest rates and their related impact on P/Es alone. The sharp move in interest rates also explains why stocks of companies with higher than average dividends did so poorly in September. If a stock yields 3% and a 10-year Treasury yields 3%, the stock might be more appealing depending on future expectations for earnings growth. But when the Treasury yield rises to 4.5%, the stock needs to be repriced to be competitive. To reprice to a 4% yield or more would require a sharp downward adjustment in price.
This all sounds pretty ugly. But let’s stop for a minute and ask whether 4.6% is a logical yield for 10-year Treasuries, or whether $90+ is a proper price for oil. Just as with the stock market, trying to predict short-term movements with any precision is a task well beyond my pay grade. In the short-run, momentum may dominate. For the moment, momentum is pushing bond yields and oil prices higher. But why should oil prices be rising in early fall? Demand for gasoline, jet fuel, and heating oil should be approaching a seasonal low. Normally, oil prices reach a seasonal bottom between Thanksgiving and Christmas. Part relates to certain countries restricting output. But we also know that nothing in the commodity trenches brings on more supply than higher prices. Saudi Arabia may still seek to keep prices rising, but if high prices lead to recession, they also lead to lower demand, something no supplier wants to see. Thus, while prices could be higher next spring without any recession worldwide, logic would suggest the recent spike in oil should run its course real soon.
As for 10-year bond yields, a classic rule of thumb is that 10-year Treasury yields should approximate nominal GDP growth rates. The U.S. economy grew a bit over 2% in Q2 and appears to be growing at the same pace or higher in Q3. But there is evidence of some slowing in September. We will get a lot of September data this week from the government. Friday’s employment report, which will be the last one before the next FOMC meeting at the end of the month, will be most important. Core inflation readings are now below 4% year-over-year. More importantly, annualizing the last couple of months, the rate is closer to 3% and falling. Thus, while current data could support a 10-year yield of close to 5% (2% growth plus 3% inflation), both the growth and inflation numbers are moving lower. Given that market prices are forward-looking, 10-year yields should ultimately reflect this. Thus, again logically, yields should reach a near-term peak soon, move back down if the economy slows toward zero growth, and then settle in a 4-5% range longer term based on real growth of 2% and inflation of 2% or a bit more.
The bottom line is that the pressures pushing stock prices lower should begin to abate soon. Then the key question is whether P/Es have fully adjusted. As noted earlier, they are still too high given current data and a reasonable outlook for the next several months. An October interim low remains a logical expectation.
I can’t end without a comment on what happened in Washington over the weekend. The first point I would make is that judging by the futures market this morning, the market has surmised that the overall economic impact of a partial government shutdown is almost inconsequential. It is also clear that given the dysfunction in Washington, nothing of consequence is likely to pass between now and the elections next year. I’m not even sure whether next year’s Presidential election matters much, at least for now. Republicans seem set on Trump, at least for now. Democrats also seem set on Biden, although if his poll numbers continue to sink, that could change. The most common criticism of Biden is his age. To me that’s a cover up. If he were popular a la Reagan or Clinton, fewer would complain. The real issue for Democrats is the public’s disillusion with progressive policies. Real inflation-adjusted income is down. Crime is up. The southern border situation is a mess. Both parties need to ask themselves why are we backing someone so unpopular to the broad electorate? In Congress, the question is why are we letting 5-20 members of the House more interested in seeing their faces on TV than legislating, dictate anything? Congress gave itself a 45-day reprieve. If Conservatives really want to pass all the appropriation bills, they have plenty of time to do that. Thus, there is no excuse for another threatened shutdown in November. But logic rarely prevails in Washington.
Today, Sting is 72. Photographer Annie Leibovitz turns 74.
James M. Meyer, CFA 610-260-2220