Stocks fell sharply yesterday taking their cues from the bond market. Since the last FOMC meeting concluded September 20th the yield on the 10-year Treasury has risen almost exactly 50 basis points (in less than two weeks). The Fed dramatically altered its stance at that meeting to adjust policy to keeping rates higher for a longer period of time in anticipation that a soft landing could be achieved. While a soft landing was considered certainly more appealing than a recession, the downside was that interest rates all along the yield curve have risen post-meeting to adjust to the change in intended policy.
Higher rates for longer also has two corollary impacts. First, higher rates will logically impact economic activity negatively with the lag effect to be determined. Second, since bonds and stocks compete for investment dollars, higher bond rates require lower equity prices to stay competitive. Today, one can build a bond ladder from 0-10 year maturities using only U.S. government securities that will lock in a 5% income stream. Whether the ladder is 0-3 years or 3-10 years doesn’t matter. Given the Fed’s target of 2% inflation, that would lock in a real return of close to 3% assuming the Fed can gain price stability. TIPS spreads suggest markets believe it can.
Let me stop there and shift a bit to bond funds. Bond funds are managed, for the most part, to maintain either a constant duration or duration within a narrow range. To maintain duration, fund managers have to sell shorter maturities and buy longer maturities. When rates are rising, and bond prices are falling, that almost always generates realized losses. Conversely, when rates are falling and bond prices are rising, they generate gains. The gains or losses are additive to the returns from interest received. The bottom line is that in a period of falling rates, bond funds usually generate higher returns than investing in individual bonds. But when rates are rising, bond funds do worse.
For most of 2023, investors poured money into bond funds, perhaps not fully understanding what happens to the fund’s net asset value (NAV) as rates rise. Those inflows continued into August. But in the last several weeks, as rates accelerated upward, they started to sell. When investors get their September brokerage statements, they will see that bond funds were just as bad as holding stocks in a weak month.
The stock market hit a bottom last October when yields of the 10-year Treasury rose to 4.3%. Stocks then staged a spirited rally through July of this year. Bonds also rallied driving yields down to about 3.25% in April. But after April, the two markets diverged. Stocks continued to rally through July while, at the same time, bond prices started to slide, particularly at the long end of the curve. By early July, the 10-year yield was up to 4.1% even as stocks continued to rally. But in August, the divergence ended. Stocks started to fall as yields continued to rise. Then came the FOMC meeting in September. Rates accelerated upward as stocks moved lower.
While all this was happening, there was remarkably little change in GDP growth rates, long-term inflation expectations or corporate earnings forecasts. Earnings have actually exceeded expectations, and I expect they will continue to do so as they report third quarter results. Despite constant fears that recession is just around the corner, both Q2 and Q3 growth were likely above 2%. Finally, TIPS spreads have suggested persistently over the past year that long-term inflation expectations remain well within the 2.0-2.5% range.
With all this said, economic concerns are rising.
1. Student debt repayments are restarting after a 3-year hiatus. There is more student debt outstanding than credit card debt. This is a big deal and will impact consumer spending patterns.
2. Real time survey data strongly suggests slower growth in September
3. Higher mortgage rates associated with higher long-term bond yields, are impacting housing demand.
4. Oil prices have shot up from below $80 in late August to over $90 recently.
5. The auto strike and other labor disputes are disruptive.
With all this said, barring a much further spike in interest rates, there doesn’t seem to be a catalyst for any sharp contraction of economic activity. Job postings are strong and rose again according to yesterday’s data release. The unemployment rate is below 4%. Layoffs (ex those strike related) are minimal. Consumers have yet to use up all their pandemic savings. Whether we ultimately slip into recession or not is still a close call. Washington has kicked the can down the road again over budget issues. The 45-day reprieve should allow Congress enough time to pass all the F24 appropriation bills. Should doesn’t mean will, especially with a Speakerless House, but if Congress wasn’t willing to shut down government this past weekend, will it really do that just before Thanksgiving and Christmas? The battle will likely go down to the wire because that seems to be the only way this Congress functions.
Thus, the two factors that have weighed on markets recently are interest rates, and to a much lesser extent, energy prices. Seasonally, there is little reason for energy prices to surge from here. The risk of significant further OPEC cuts is small. As for interest rates, one can argue that 10-year yields between 4.0% and 5.0% are consistent with growth of 2%+ and inflation of 2% or a bit more long-term. That doesn’t mean rates can’t move higher strictly based on momentum.
There are two equally likely economic scenarios for 2024, a soft-landing or a recession. If there is a recession, the Fed will respond with a series of rate cuts pulling the Fed Funds rate back below 4%. The yield curve will un-invert. Investors will scramble out of money market funds (whose yields will fall to mirror the Fed Funds rate) to lock in higher rates closer to 5%. That will increase demand for longer dated bonds, pushing prices higher and yields lower. As for stocks, it will be a battleground between higher P/Es (consistent with lower interest rates) and reduced earnings expectations. Stocks normally bottom early in a recession as investors look past the trough in earnings toward economic recovery. If there is a soft landing and inflation continues to ebb, the reduction in the Fed Funds rate will happen more slowly. But earnings expectations would rise as the economy continues to grow. While P/Es will rise more slowly commensurate with a slower decline in rates, the earnings outlook will be much better without a recession.
All this plays into a near-term forecast that suggests the panic in the bond market will likely run its course soon, setting the stage for a reasonable rally. Earnings season begins in mid-October and should be a positive thrust overall. Days like yesterday are always tough to swallow. By all technical measures both stocks and bonds are oversold, but that doesn’t mean they won’t be more oversold at the end of today. We are entering the phase where emotion trumps logic. On a positive note, that phase is usually short-lived. Get your shopping lists ready.
Today, Susan Sarandon is 77. “Bull Durham” is one of my all-time favorite movies. Also born on this date back in 1822 was Rutherford B. Hayes, the 19th President of the United States. If ever there was a stolen election in this country, it was the 1876 election that made Hayes President. I won’t be a spoiler and tell the whole story but it’s a great read if you want to go back into history and look.
James M. Meyer, CFA 610-260-2220