Stocks continued to slide Friday although NASDAQ names got a bit of a lift from a strong earnings report from Amazon. Bonds traded within a narrow range. Despite a growing economy, full employment and falling inflation, stocks have been under a lot of pressure since the start of August.
The primary culprit has been the sharp rise in interest rates on long-term bonds. The sharp rise in rates brought about an attendant decrease in the value of these bonds. The spike in yield has been noteworthy, rising from about 3.7% in June to 5.0% last week. That’s a 35% increase in just three months. A lot of market watchers put the blame on an expanding deficit. While there is some truth to the linkage between deficits and rates, note that less than 20% of Federal debt outstanding carries maturities of 10 years or longer. Another culprit has been the increasing use of derivatives by traders trying to capture and leverage short-term moves in bond prices. When a large majority of traders are on the same side of the trade, outsized movements in price follow.
No one can tell us when this spike ends, but there are fundamental indicators that suggest the worst is probably over. The term premium for bonds is positive once again. Money now has a real cost all along the yield curve. As to the shape of the curve, it began to invert in July 2022. Now it is starting to flatten appreciably. While still inverted at the short end of the curve (less than two years), 5-year yields are now less than 10-year yields. 3-year and 10-year yields are virtually identical. Yield curves generally invert in advance of an economic downturn. The average lead time between the start of inversion and the start of a recession (assuming one occurs) is about 18 months. Yield curves return to a normal ascending shape near the start of any recession or at the point of lowest growth. As for now, that seems a bit contradictory given the recent Q3 GDP report that showed growth of close to 5%. Even taking out the lift from inventory buildup, the Q3 gain was about 3%.
Consumer spending, which accounts for over 2/3 of GDP, has gotten a sustained lift despite higher rates from three sources. One, employment is full and people who work spend. Second, at least until the past two months, consumer net worth has risen throughout much of this year buoyed by rising stock prices and high home values. Finally, consumers are still living off the excess savings built up during the pandemic courtesy of excessive fiscal largesse.
But that may be about to change. Student loan repayments resumed in October. The stock market and bond markets have both fallen over the past three months. Stocks are down over 10% from their recent peak. Consumer savings rates are now half of long-term averages. Continuing jobless claims have begun to rise even as new claims remain low. Since the 1960’s, an upward slope to continuing claims has been an almost perfect harbinger of a recession within a few months.
With that said, a recession doesn’t have to be feared. There is little reason to expect any downturn to be severe. Partly due to the aftereffects of the pandemic, some economic sectors have been in recession for some time and are even starting to recover. Personal computer sales are a case in point. While home builders are still doing well, home sales are down appreciably dragging with them sales for everything from furniture to gardening services and equipment. Should a recession extend for more than a few months, the Fed would almost certainly start to lower interest rates, not back to zero but enough to mute the severity of any downturn. Most importantly, stock markets are leading indicators. The move down today is, in part, a sign of increasing fears of a pending recession. After a recession actually begins, stocks will look to the horizon for signs of clearing skies rather than the rain clouds directly overhead.
With 10-year Treasury yields now at 5% and inflation below 4% and sliding, the real cost of money will rise even while the Fed stands pat and does nothing. That is why virtually everyone expects the Fed to remain pat this week at its FOMC meeting and leave rates where they are. The recent drop in oil prices, and especially for gasoline, will allow headline inflation for October and November to ease a bit more than might have been anticipated a few weeks ago. Shelter costs, the most important contributor to inflation data, are also growing at a slower pace.
Thus, over the next few months, the pace of economic activity is likely to slow, although GDP will probably still grow for another quarter or two. Inflation will continue to recede. It’s hard to make a strong case that long-term interest rates will keep rising under that scenario. If rates stop rising, the focus will return to earnings. Q3 earnings have been pretty good. The big report this week will be Apple#. Expectations are fairly muted. The new iPhone 15s don’t have a significant set of new features. iPhone sales will likely be down year-over-year. That is already built into the price of the stock. But Apple continues to generate lots of cash, is highly profitable, and still has growth opportunities in the future. The stock has been weak lately signaling apprehension over its pending earnings release. But Apple’s news, good or bad, is unlikely to impact a wide range of other companies, most of whom have already reported.
One other point of note. Companies are barred from repurchasing shares until after earnings are reported. Stock buybacks are an important part of the supply/demand equation for stocks. The end of October is also the end of the fiscal year for most mutual funds. That often causes some window dressing whereby funds sell their big losers so they don’t have to show them in their year-end reports. Window dressing ended last week. Trades today don’t settle until November 1. Markets rarely go in one direction for long, up or down. Some relief should be forthcoming. Valuations are still a bit high but much closer to normal than they were two years ago. Good investors look forward, not backwards. While a recession would put near term pressure on earnings, it would also lead to lower interest rates. It’s time to take a deep breath, control your emotions, and create a shopping list.
Today, Henry Winkler, the Fonz, turns 78. “Aaaaay!”
James M. Meyer, CFA 610-260-2220