Stocks fell for the fifth straight session as bond yields continue to rise. Overnight the yield on the 10-year Treasury reached 4.0% but backed off about 10 basis points after the Bank of England announced it would temporarily buy long dated bonds in an attempt to stop the rapid decline in the value of the pound. That, of course, is simply a stop-gap measure that won’t work over time.
The Fed has said in no uncertain terms since Chairman Powell’s speech in late August at Jackson Hole, that it wants to raise short-term rates rapidly to a point where enough pressure is put on the economy to help bring down inflation rapidly toward its 2% target. Fed Fund futures rose immediately and have continued to rise. They now show a market decision that short rates will reach a peak of 4.75%. It is possible that Fed Funds futures could reach 5% before the process is complete, most likely in the first quarter of 2023. From that point on, the Fed intends to keep rates elevated until there are clear signs that inflation is on a glide path down to 2% or lower. According to the Fed dot plots, that means rates will stay elevated until sometime in 2024. But voices outside the Fed have expressed thoughts that the Fed is moving too fast raising fears that it will cause not only a recession, but one more severe than necessary to win the battle. The sharp rise in interest rates has spilled over into other markets. While equity investors see the spillover in lower equity prices, perhaps the key risk has been the rapid rise in the value of the dollar and the collapse in value of other currencies around the globe. Today the dollar is at an all-time high, for instance, against the British pound. Why should we care? If you are a tourist, now is the time to visit London. If you are a Brit, living in an economy headed into a deep recession post-Brexit amid a war in Ukraine that has led to skyrocketing energy prices, the escalating value of the dollar means a sharp rise in import costs above all the other factors. Britain’s new government is proposing a host of interim measures to stem the tide including support payments to offset the spike in energy, and today’s announcement of bond purchases. Subsidies are already 6.5% of GDP. Britain’s deficit is rising at a rapid pace. Debt service costs will rise even faster.
The problem isn’t just in Great Britain. China’s yuan, normally pegged between 6.0 and 7.0 to the dollar has now fallen to 7.2 and still falling despite the fact that inflation in China is well below 3%. Lesser developed nations, who must import so much, are going to be hurt severely as the dollar keeps rising, the result of the US raising interest rates faster than the rest of the world.
Back to our country, we have yet to see much economic impact. Yes, housing has turned down and so have most commodity prices, but wages are still rising. GDP is about flat, the same pace as the first half of the year, maybe even a little better. The impact of higher rates usually takes 6-12 months before its effects are fully realized. Only this summer have rates reached a level that start to squeeze.
In the equity markets, the impact of higher rates is not only lower P/Es but a compression of multiples. Stocks represent the present value of future cashflows. For growth stocks, their big earnings days are years out in the future. Higher interest rates mean a higher discount rate to be applied to those future cash flows. Compare that to a company that earns a lot today but is barely growing. The same discount gets applied to future earnings, but the number in the near term has greater importance. That is why, when rates rise, especially when rates rise rapidly, growth stocks get clobbered. Value stocks also fall, but at a much slower pace.
Of course, rates won’t go up forever. The steps taken by the Fed will crush inflation. A Fed Funds rate of 4.5-5.0% will get more and more expensive in real terms as inflation falls. Core inflation today is a shade over 4.5%. It is falling. Virtually all non-government borrowers pay a premium to the Fed Funds rate to borrow. The current prime rate is 6.25%. There is a real cost to borrowing and it is rising. At some point, both inflation and employment fall to a point where the Fed will feel comfortable letting interest rates decline to a neutral rate, one that represents a slight premium to the ongoing rate of inflation. Longer duration bond yields will settle at a rate higher than the Fed Funds rate. In my head that suggests a long-term Fed Funds rate not far from 2.5-3.0% and a long-term yield for sovereign debt close to 4%, about where it is this morning.
That may seem shocking in a way. Is 4% the new normal for long-term yields? Will money market funds in the future pay close to 3%? What’s shocking is the pace at which bond yields got to their current level. What may become shocking is the pace at which the economy responds to the higher yields. In fact, I think the odds of a financial crisis over the next few months is high. The exact character of the crisis isn’t clear. It could revolve around Great Britain. It could revolve around another nation(s) unprepared for higher debt service costs and a weak currency. It could relate to leveraged investments gone bad. I don’t know, but almost every sharp downturn reveals a crisis. Remember Long Term Capital Management in the 1980s? The collapse of the Savings and Loans before that? Lehman Brothers a bit over a decade ago? These events all happen at the abyss of the cycle. They tell the government, enough is enough.
There is another cost to all this. Jim Vogt addressed it last Friday. Excluding debt held by government agencies like the Fed, there is a bit over $20 trillion of debt in public hands. The Fed’s QT policy of bond liquidations adds $60 billion per month. As tax receipts dwindle and Federal spending rises, deficits will increase. Not long ago, debt service costs were about $250 billion, between 1% and 2% of debt outstanding. At 3%, that cost soars to over $600 billion. Every additional percentage point adds another $200 billion without counting any further increase in debt outstanding. Debt service is a cash expense. It can’t be whitewashed away. Yes, our government can simply print more money but there is an unknown breaking point and, if the U.S. faces a future debt service issue, what about every other country?
After the Great Recession, governments and central banks flooded the world with money. Cheap money. Money that had no real cost. Too much money. The excess went toward asset purchases: stocks, bonds, bitcoin, and houses. It also fostered bad investments. Too many skyscrapers, too many retail stores, too many websites. Venture capitalists funded too many bad businesses.
At the start, with so much excess capacity left over from the recession, the extra investments raised asset values without creating recession, but governments and banks left the lid off the cookie jar too long. We even paid unemployed workers twice the minimum wage to sit on their couches or go surfing. Inflation was inevitable. The time came to put the lid back on the cookie jar. No more cocaine. It was time for withdrawal.
Welcome to withdrawal. That’s never fun. In the end, balance is restored. By this time next year, inflation should be well below 3%. Wage demands will slow as the economy does and as employment opportunities disappear. The pattern of quitting one job to take another at a pay level 20% higher is stopping just as the lines waiting to buy a house over the asking price stopped months ago. Long term we want balance.
Balance will be a reversion to the mean. In the stock market, a mean is 15-16 times forward earnings for the average company. Companies with fabulous future prospects will still thrive but their stock prices will have to adjust to the new norm. 20 times earnings will replace 20 times sales. If the S&P earnings this year are $225, to get back to the old highs of 4800, assuming earnings growth of 6-7% per year after a brief earnings recession, could take 5 years. That’s an average. Some stocks will get back to old highs in a year or two. Others might never reach former peaks.
6-7% earnings growth, plus a dividend is still a nice return. Stocks will stop going down when interest rates, particularly long rates, stop going up. Today, long bonds, provide a real return of about 1.5%. Not long ago, their returns were negative. Long bond yields could go to 5% or more, but I doubt it. We will get to see September employment numbers next week. Any decline from August numbers over 300,000 will be viewed favorably. A week later, hopefully the CPI report will show some signs inflation is slowing. Note that rents seem to be peaking while home prices are starting to decline. That won’t show up in the CPI numbers for a couple of months.
As inflation data shows a declining pace, stocks will bottom. I said I expected the bottom in October. I really can’t be that precise, but I do think that investors will soon be looking out to mid-2023. As the Fed accelerates its pace of interest rate increases, the likelihood increases that the impact of those rate rises accelerates. To investors, that means a faster deceleration of inflation and economic growth. If that happens, the Fed won’t wait until 2024 to cut rates; it will do so sometime in 2023, probably after mid-year. Although the Fed may wait 12 months or more to cut rates, markets will anticipate and adjust sooner. Once the 10-year rate starts to decline, stocks will advance. In a bear market, the nastiest time is at the end. We may be close to that moment.
Today Brigitte Bardot turns 88. I don’t ordinarily talk about people no longer with us but I was intrigued to find out that Confucius was born on this date in 551 BC.
James M. Meyer, CFA 610-260-2220