Interest rates continued to moderate, helping to lift stock prices once again. Over the past couple of weeks, yields on 10-year Treasuries fell by about 5% to 4.10% and lifted equity values in the process. The decline coincided with some signs of economic weakness, notably a drop in the number of job openings and a sharp decline in the number of Americans quitting their jobs to rotate into higher paying alternatives. While layoffs remain low, clearly inflationary pressure in the labor market is starting to subside.
The impact of higher rates is finally starting to be felt. In some cases, the impact was immediate. Since the Great Recession, American home buyers have financed purchases with 30-year fixed rate mortgages. While mortgage rates for new loans today are near 7%, the average mortgage rate is only about 3.6%, testimony to those who bought or refinanced when rates were super low. Rightfully, they don’t want to give up their low-rate debt to move and take on a 7% mortgage. Thus, home sales, a combination of new and existing homes, are currently near a decade low. Uncharacteristically, home prices have held up, largely due to a dearth of inventory of homes for sale, once again courtesy of the low rates.
The same may be happening with cars. Car loans typically are 3-7 years. Americans keep their cars an average of 7 years. Those who bought 2-4 years ago with super low rates now face decisions. Do they keep their existing cars longer? Do they trade them in for a cheaper car to offset higher finance costs? Those who opted for leases find they can buyout their leases at favorable terms given that the value of their cars today often exceeds the buyout prices within their leases courtesy of inflation over the past few years.
Retail customers are saving less and spending more. Spending in July rose by an 8%+ rate thanks to attractive travel deals and Taylor Swift concerts. Now that credit card debt has to be repaid.
Corporations took advantage of the low rates and refinanced existing debt at very low rates. They are still reaping those benefits. But corporations rarely borrow for 10-30 years at fixed rates. Most borrow for about 5 years. Corporate debt maturities will double over the next 2 years and rise by 150% by 2028. Over $1.5 trillion in commercial property loans come due within the next two years. That debt will have to be refinanced at higher rates.
The government faces similar issues. The U.S. Treasury lengthened maturities substantially during the years of easy money. Average maturities are now over 5 years. But that debt eventually comes due and will have to be refinanced. Average debt costs today are 3.4%. As a reminder, six-month rates today are over 5% and 10-year rates are over 4%. The Fed won’t keep rates high forever, but futures markets predict long-term Fed Funds rates will settle at 3.5% or higher. Add into the equation all the new debt that will be issued in the interim and you can see the problem in front of us.
Debt service, now just over 1% of revenues will rise sharply across the economy over the next several years squeezing margins. Will businesses be able to offset this or pass the increases on to consumers? If 2023 is a guide, the answer is only in part, as profits this year are falling in the corporate world even as sales continue to rise.
But aren’t there beneficiaries? Yes, there are. Savers are the big winners. $1 million in the bank just a few years ago yielded less than $1,000. Today, with money market fund rates near 5%, that same nest egg provides $50,000 in income. For retirees, that would now exceed what they get from Social Security. It gives seniors a little more leeway to travel or to support the needs of their kids. Certainly, one economic reality holding up the economy today is generational wealth transfer either through death, gifting, or some other tax saving alternative. Estate tax exemptions, under current law will be reduced sharply after 2025. The odds of any extension depend on the makeup of Congress and the White House after the 2024 election. If the large exemptions that exist today are allowed to expire, there will be a surge in transfers happening in 2025 even though only a small fraction of Americans are directly affected (i.e., those with multi-million dollar estates).
Pulling this all together, stocks for now remain hostage to the change in rates. Today’s employment report may move the needle a bit, but it is only one data point. Clearly, the economy is slowing and the pressure of high rates will continue to increase in the months ahead. Government outlays remain high, forcing Treasury to issue a lot more debt over the next 1-2 years at least. Increased supply will push rates higher. Lower demand for goods and services will push rates lower. Thus, at least for the near term, I see rates stuck in a range. If I wanted to suggest a wide range for the 10-year bond, I would suggest 3.5-4.5%. the lower end would be tested should there be a pending recession. The upper end would be tested should inflation force the Fed to move rates higher again before year end.
As for earnings, I see no change in trend for the next few quarters. Some hope for a significant rebound later in 2024 but that is depending on so many unknowns today that any prediction today would be no more than speculation. But what one can expect is that the delayed pressures of higher interest costs will intensify in the months ahead. They will be most impactful to industries and sectors that are debt dependent. Banks, in particular, face a lot of uncertainty as the confluence of economic softness, higher rates, leverage, and overbuilding combine to accentuate pockets of weakness. We aren’t about to face a repeat of the crisis times of 2008, but the bank failures of this past spring remind us that levered balance sheets carry increased risks in difficult times.
For sure, there are parts of the economy that can escape these issues. Those companies with modest debt and growing revenues can continue to thrive. We see a lot of these in the technology sector but many others exist in the consumer, health care, and business services worlds. In 2023, with stocks overall up 10-15%, there are many that are up over 50% and many that are down year-to-date. For many companies comparisons to last year are complicated from the aftermath of the pandemic. We are less isolated this year spending on experiences rather than fortifying the home office. Thus, hotels are doing great while PC manufacturers have been suffering. But there are signs that PC demand is bottoming. Those computers bought in 2020 may need to be upgraded soon. That vacation of a lifetime taken this year may not be repeated next year. The one constant is change.
As noted earlier, the recent decline in bond yields has helped to lift stocks. The fundamentals within the economy are slowly deteriorating, but 5% moves in the bond market will be a much more important near-term factor than slow economic changes. In addition, as we enter the last third of the year, tax selling will become consequential. Those with big gains may defer realizing them until next year or later, while those with unrealized losses will want to take them to lower taxes. That’s why, at least until well after Thanksgiving, 2023 stock market losers face a tough time.
Without a lot of data amid a slowly deteriorating economy, September is a month to be careful. Make a list of stocks you want to buy, select your entry points, and hope you can catch a bargain or two before the end of the month.
Today, Gloria Estefan is 66. Dr. Phil turns 73 while the last remaining BeeGee, Barry Gibb turns 77.
James M. Meyer, CFA 610-260-2220