Stocks rebounded on a busy earnings day. Old line names like Coca Cola#, 3M, and General Electric helped to lead a rebound. But as important as earnings reports are at the moment, stocks still take their primary cue from the bond market. 10-year Treasury yields fell back from their recent 5% peak helping to lift equity prices.
The yield curve has been steepening. Whereas the entire curve has been inverted for months, beyond 2 years, it is starting to look rather flat. The 2–10-year Treasury spread, which not that long ago exceeded 100 basis points, is now less than 25. The 5–10-year spread is now just 2 basis points. The most inverted part of the curve is at the short end. The 3-month to 2-year spread is still inverted by about 60 basis points. Most of the flattening or steepening has come about from investors shifting dollars from the long end of the curve to the short end helping to lift longer duration yields. Short-term returns are anchored by Federal Reserve actions. Currently the Fed Funds rate is 5.25-5.50%. Yields for maturities of less than a year are anchored near the high end of the Fed Funds range. For much of the recent past, they have been higher, representing a belief that future rate increases were coming. Today, the message is that markets think the Fed is done.
As one looks out further on the yield curve, the Fed Funds rate becomes less of a determinant of price. Gaining influence are a composite of expectations for future economic prospects and the forward path of inflation. All agree inflation is receding although there isn’t firm agreement on the pace. As for economic growth, it has been surprisingly strong. Everyone has been waiting for signs of an expected slowdown. But so far, propped up by excess cash built up during the pandemic, Americans keep spending.
To be sure, there are pockets of weakness. Home sales are back to recession levels, pinched by high interest rates. From a GDP viewpoint, however, housing is still robust. A sale of an existing home is not part of GDP; it’s simply the transfer of an asset. Only construction matters. That includes both new homes and remodeling. New home builders continue to thrive helped by demographic trends and large backlogs. The largest builders are offering mortgage support to buyers, often lopping as much as two percentage points off the cost of a mortgage. Thus, while overall sales activity in the housing market is slow, home builders are capturing close to a third of the transactions, far above the norm of 20-25%. Thus, from a GDP perspective, the housing market looks a lot better than one might think. Buyers are also switching to adjustable-rate mortgages at the fastest pace since the Great Recession hoping that 8% mortgages are temporary.
While high interest rates are starting to pinch other economic segments, like auto sales, Americans are still flush with cash, although the stockpile is dwindling, and they are still gainfully employed. During the pandemic-fueled recession, the unemployment rate briefly reached over 10%. Today it is under 4%, amid an economy that continues to add an average of close to 200,000 jobs per month. Demand is also fueled by rising immigration, both legal and illegal. While Washington is slow to issue work permits, particularly to those coming through our Southern borders, these people have to feed and house themselves in some manner. Within a tight labor market, they find opportunities often filling the jobs few others want, especially when job opportunities for all are plentiful. Much of what they are earning comes under the table and is not officially counted. How much is uncertain, but it adds fuel to a growing economy.
Monetary velocity has picked up. Velocity measures the pace at which money changes hands. In good times, velocity rises. It often starts to roll over immediately ahead of a recession as consumer apprehension increases, then drops through the recession as people hoard resources. Lately, it has been very strong, rising about 14% over the past two years offsetting a decline in the money supply, part of the Fed’s tightening regime. Also note that M2, the broadest measure of money, only counts what is seen, i.e., what’s in the banking and money market fund systems. It doesn’t count movements of cash that stay out of the banking system.
Will there or won’t there be a recession? Again, that’s a close call. While estimated Q3 growth close to 3-4% is unlikely to be matched going forward, there are few signs that an imminent economic decline is going to happen. While retailers are worried about Christmas, it is hard to see how employed Americans are going to pull back much. As the excess cash hoard dwindles, there may be some hesitation to be excessively exuberant. Moods can change quickly. While the air is currently poisoned a bit by war, labor strikes, and politics, the average American pays little attention to events that don’t affect them directly.
We see this yin and yang in earnings season. Generally, results reported for Q3 have been good with very few exceptions. But managements see an uncertain future and are offering tepid and varied guidance. Many companies are still feeling the aftereffects of the pandemic. Medical companies that got a boost from Covid-related sales are suffering as those sales dissipate. Others, whose fortunes are tied to hospital procedures, are seeing a pickup as people become less scared of being within a hospital environment. Look at the PC market. It boomed during the pandemic as Americans equipped themselves for stay-at-home or work-at-home modes. Then, in 2022 sales collapsed. One doesn’t need a new PC every year. But now sales of PCs have shown signs of bottoming. That doesn’t mean boom times are about to return, but it does mean a return to normal is probably close at hand. Thus, depending on company or industry, some businesses are still on a downslope as Covid-related boom times fade while others are benefiting. These trends vary from industry to industry. In some cases, rebuilding supply chains is a help. In other cases, too much inventory has to be liquidated. There is no one common theme. Thus, individual companies and industries follow different flight paths.
Perhaps there is no greater example of the impact and aftereffects of Covid than the commercial real estate market. In 2019, we mostly worked in the office. In 2020, after the pandemic began, we all worked at home. As the pandemic subsided, our patterns changed. Working from home had its advantages and disadvantages. Some still work from home. Others work from home some of the time. Employers have been pushing to get people back in the office. Collaborative work suffers from separation, even allowing for the benefits of using Zoom. Investors worried that empty offices meant tenants would not be able to pay the rent. Businesses downsized office space. Some vacant space was converted to alternative uses. The saga still has to play out. In some cases, excess space and lower rents mean a sharp decline in the value of office buildings and, in some cases, defaults and bankruptcies. But the cries of doom that reached a peak last spring amid several high-profile bank failures may have been overdone. That’s not a prediction of boom times ahead for downtown. But it does suggest a long-term reshaping of what downtown will be like years from now is underway. Good old entrepreneurship will avoid the worst outcomes.
Perhaps that thought needs to be applied to the stock market. Sectors that led the market in 2022, like energy, consumer staples, utilities and health care, are having a tough 2023. Sectors that lagged in 2022, notably high tech, have rebounded strongly in 2023 as companies controlled excessive spending and found new opportunities like AI. I suspect there will be more rotation in 2024. Companies feeling the lag effects of the unwinding of Covid’s economic impact will start to recover. Companies that enjoyed a comeback in 2023 as supply chains healed will settle back to more normal trends next year. I am not great at predicting interest rates (heck, the Fed doesn’t do it very well either!) but if inflation is falling and growth is either tepid or falling, it is hard for me to make a case that interest rates a year from now will be higher than they are today. Indeed, it is more likely than not that a year from now the yield curve will no longer be inverted. If rates decline and the yield curve returns to a more normal pattern, this could serve as a tailwind for many industries that suffered in 2023 including banks, utilities, and consumer staples.
At the same time, one should remember that bond cycles are long. Yields rose from the end of the Korean War until about 1980, then basically fell all the way through the Covid pandemic. Now a new cycle has begun. The trend is clearly higher for longer. That doesn’t contradict the short-term relief in rates I just alluded to. But it does mean short rates aren’t going back to zero and long rates won’t go back below 2% for a very long time. Businesses and individuals will have to react to a world where money has real costs. It may mean slower demand but it also will retard stupid investments, leading to improved productivity. Slower but more productive growth is a good thing to look forward to.
Today, Xander Schauffele turns 30. Katy Perry is 39. Remember the 1980 miracle on ice? Today, Mike Eruzione, the team captain of that Olympic squad turns 69.
James M. Meyer, CFA 610-260-2220