Stocks staged a modest rally yesterday after bond yields retreated following a spike in yields overnight. The rally also relieved a short-term oversold condition. With that said, there was little in yesterday’s rally that would encourage investors that the August-September correction is over. That would require strong follow through today and Monday.
There was little in the way of new news yesterday that should sway investor sentiment. After the close, Fed Chair Jerome Powell, speaking to educators, made no attempt to step back from the hawkish tone of last week’s FOMC meeting. Instead, he hammered home the point that the dot-plots were intended to send a message that rates would likely stay higher for longer than consensus at the time suggested. Bond yields spiked to over 4.65% for 10-year Treasuries yesterday morning before falling back to 4.55% overnight. Certainly, the rather sudden moves in Treasury yields over the past few weeks has been a primary factor leading to the current market correction.
But the move in stock prices isn’t just about yields. Survey data suggests a weakening economy although one that is still growing. Weekly jobless claims hover just over 200,000 suggesting a solid labor market continues. While job growth is always a good thing, it doesn’t help the battle against inflation. It supports the notion that interest rates will stay higher for longer.
With that said, higher for longer has to be taken into context. Higher for longer means the days of 3% mortgages, a 1-2% Treasury yield, and virtually no return for cash assets are over. It will most likely be at least a generation before yields like we saw soon after the start of the pandemic will return. But higher for longer, if compared to what normal was over the past century, isn’t very frightening. A 3% Fed Funds rate, a 6% mortgage and a 4% return on cash are all close to the mean over the last 100 years. Yes, today, rates are a bit above the average because the Fed is trying to bring inflation back to 2%. According to the recent FOMC dot-plots, that process may take 2-3 more years. It could be less if the Fed wanted to take draconian steps that would crush the economy over the short-term. But that makes little sense. We still may or may not face a mild recession, but inflicting a severe recession just to stop inflation in its tracks isn’t a policy anyone would recommend. Therefore, we will endure rates somewhat above average for a period of time. The Fed doesn’t have to wait until inflation is all the way back to 2%; it simply has to wait long enough that the path toward its goal is clear.
There is little question that companies are forced to operate differently in a world where there is a real cost to borrowing as opposed to one where money is free. Too much debt gets very expensive. What’s too much? If you own a home with a 30-year mortgage at 3%, you can endure more debt than a buyer today paying 7%, as long as you stay put. If you are a corporation, your ability to service debt determines how much you can borrow. Paying 5-10% is clearly more limiting than when the cost is 3% or less. If you are just an average consumer, it pays to be attentive to credit card balances. If one lives hand-to-mouth, only making minimum monthly payments while continuing to spend like they did a year or two ago, credit costs can escalate quickly. At the moment, 30-day past due balances aren’t far from normal levels. But they are rising quickly and soon could be a cause for concern.
Banks get impacted by these changes. With a flat or inverted yield curve there isn’t a normal borrowing spread. To compensate, they charge more, which of course discourages borrowing. They also have to be attentive to loan quality. I often say my 3-year-old granddaughter can lend money as easily as any bank. The difference is she won’t be very good getting her money back. By now, you have all been reading about growing problems in the commercial real estate market. Empty office buildings provide insufficient cash flow to pay off debt. In 2023 and 2024, a record number of new apartments are coming to market. In a soft economy, that could lead to more concerns. Bank responses are to tighten lending standards, a step that will further retard growth.
The economy has its short-term problems such as labor strikes and a possible government shutdown. But these will be settled within weeks. They could impact Q4 GDP but will have hardly any impact on next year. The economy also has its long-term problems. Government spending is out of control. The U.S. government is likely to have to raise an additional $2.5 trillion over the next 12 months, inclusive of the fact the Fed will continue to reduce its balance sheet by $1 trillion. At higher rates, that debt gets more expensive to service, adds materially to the deficit, and ensures even more borrowing in the future. Politicians on both sides of the aisle are unwilling to tackle entitlements while growth in Social Security and Medicare alone rise by hundreds of billions of dollars each year. The same extremists who want to shut down the government pandering to their own supporters, are equally unwilling to tackle those problems that are the dominant contributors to rising deficits. The first thing Congress should do next week if there is a government shutdown is to withhold their own pay.
As investors, we don’t buy stock in Congress. If we could, we would probably short it. We buy stakes in companies betting they will grow, adjusting to any changes that impact their business. In a rising rate environment, that means controlled borrowing, refinancing when necessary, investing more prudently, and focusing on growth opportunities. Clearly, some businesses are less dependent on changing economic conditions than others. If you have a headache, you take a pain reliever in good times or bad. But when times are less certain, you might hold back from buying a new shirt or dress. As investors, we too must take economic conditions into account.
While the economy is slowing, it doesn’t do so evenly. In some cases, growth might even accelerate. Perhaps a company’s activities center on infrastructure rebuilding. Those expenses, mostly paid by the government, will rise next year. The rise of wonder drugs to treat obesity while lowering heart risk have all sorts of implications, not just for the makers of those drugs. If you lose weight, you need new clothes that fit. If you lose enough weight, maybe that knee replacement can be deferred. Diabetes will become less of a scourge. Technology offers opportunities in good times and bad. There is a massive increase in demand for high-powered semiconductors based just on the growth of Generative AI. All the software taking advantage of AI’s power will come later. The list goes on. Electric cars. Charging stations. Carbon capture. Technology also causes disruption. Only Tesla is making money manufacturing electric vehicles today. Only Netflix is making money streaming. That situation cannot persist. Indeed, where many feel the auto and TV industries are headed may be all wrong.
The bottom line is that the economy is simply one factor contributing to the investment equation. Over the long-term, it becomes less and less important. There will always be upturns and downturns. Over time, the good times dominate. Right now, valuation is taking center stage. Earnings are stagnant, profit margins are being pressured, and equity prices are adjusting to rising interest rates. There is little reason today for 10-year Treasuries to yield more than 5%. Normal is usually something close to nominal GDP growth, a bit over 4%. That doesn’t mean rates can’t go over 5% soon, but it doesn’t suggest that if they are to stay there, either inflation has to reignite or growth has to suddenly accelerate. Both seem unlikely. Thus, while stocks still could decline another 5% or so coming into earnings season, most of the damage from higher rates has already happened. Stocks still aren’t cheap, which allows for a bit more selling pressure, but within 2-3 weeks we will be in Q3 earnings season. If GDP data is at all accurate, earnings should be OK. As always, the outlooks expressed by corporate managements will matter more than the earnings themselves. While they will be subdued, the recent correction discounts some of that sentiment.
It’s still too early to be a buyer, but I suspect this correction will likely run its course over the next 2-3 weeks.
Today, Kevin Durant is 35. Andrew Dice Clay turns 66.
James M. Meyer, CFA 610-260-2220