A one-day respite from an exploding bond market was welcome and overdue news. However, yesterday stocks gave back all of the 2% gains seen following the Bank of England’s surprising announcement on Wednesday. The BOE’s intention to restart purchasing 10-year Gilts helped drive interest rates substantially lower. Over the pond, they saw their 10-year bond drop by 50bps in just one trading session to sub 4%. Even more remarkable, their 30-year bond dropped over 100bps after rising from 3% to 5% just in September. Imagine buying a bond at a 5% yield in the morning and selling it at 4% in the afternoon. That equates to a 30% price move in a few hours.
Inflation remains BOE’s primary focus but their bond market was not functioning properly, requiring intervention. This is supposed to only be for a couple of weeks to help add stability. This does not end their desire to keep raising rates and fighting inflation which is tracking at a 10% rate. With a Government that is cutting taxes in order to boost growth, while also handing out cash to help pay for rising energy bills and a bank trying to fight inflation, we are entering a period of mass confusion for England. This strategy does not compute, bordering on insanity. Avoiding margin calls on UK pension funds and preventing fire sales by normally solvent firms is one thing. Cutting taxes, increasing money supply and handing out cash/pounds to citizens is a completely different plan, which only adds to uncertainty.
Domestically, we have a ~$400B student loan forgiveness program being taken to the courts while also battling inflation. How one expects to beat high prices with more Government handouts is beyond my comprehension, but here we are. Our 10-year Treasury rate touched 4.10% pre-market on Wednesday before closing under 3.70% after the BOE announcement. Yesterday, it rose back up to 3.75%, helping drive another risk-off stock reaction. Much of Thursday’s move can be explained by a relatively strong labor market update. Again, good news is bad news right now. The stronger our labor force continues to be, the more likely Fed officials keep pressing the needle and raising interest rates. Every 25bps higher equates to an increasing likelihood of a policy mistake and a deeper recession, as opposed to the soft landing everyone is hoping for. Growth and cyclical stocks took the brunt of selling pressure.
Bond Market Malaise:
Many of us own fixed-income securities as an asset class in order to provide stable income streams, and normally, added protection during volatile market environments. For the past 40 years, when stocks went down, bonds went up. This year has been very atypical to say the least. However, the staggering interest rate moves are welcome news for future investors and get markets back to normal, where interest rates now offer some premium to a risk-free rate. Eventually, inflation will come down and bonds bought today will also offer growth over and above the rising price of goods and services.
However, the speed and depth of this move has wreaked havoc on balance sheets, investment portfolios and Government entities alike. It is one thing to get back to “normal.” It is another to have it all jammed down our throats in just a few months. According to Gavekal Research, the market cap of U.S. equity and fixed income losses add up to nearly $20 trillion this year. Globally, it is estimated to be over $32 trillion. Since the fixed income market is much larger than stocks, the brunt of losses has been felt by bond holders.
This is also global in scale as international markets are seeing spiking interest rates as well. This breakdown is a major reason why the Bank of England had to intervene and stabilize their malfunctioning bond market by buying long-term debt. Below you can see how deep and extraordinary this destruction has been across the globe.
Bond Market Opportunity:
For every bearish environment, there are bullish implications. We have already discussed the benefit for savers. Money-market funds are back to offering 2%+ yields. Banks are slow to give checking/savings accounts higher rates, but they are coming. Bond investors can now lock up 4% tax-free returns from numerous states. Corporate bond investors can get 5% – 8% depending on risk tolerance.
Lastly, the massive underfunded pension liabilities across the globe are starting to get back to being full. Most of these pension plans have shifted their investment strategies towards a liability matching or “immunization” strategy. This occurs when a plan attempts to match future payments with cash flows from current assets. When interest rates were near zero, it meant dipping into higher dividend paying stocks and adding risk. It also meant most liabilities were underfunded. Today, the largest 100 corporate defined benefit pension plans are actually OVER funded! Quite the turnaround from the prior decade. Glass half full?
Stock Market Opportunity?
With Q3 coming to an end, investors are assessing the damage. While one day’s portfolio value should not change investor’s long-term focus, it is clear that a lot of bad news has already been priced in. The Nasdaq is 35% off its recent highs. Every major index is technically in a bear market, with the Dow hitting the 20% threshold including losses this week. World class companies like Nvidia, Square, Facebook#, Adobe#, Ford, Nike, FedEx#, Toll Brothers and Sherwin Williams are down over 50% from their recent highs. Those are massive losses, although most of these stocks and indices provided substantial gains prior to 2022.
Today we have historically bad market breadth (almost all stocks are down except for Energy and some Defense stocks), bearish advisors are at record levels, major averages are on support levels, VIX has already spiked, bonds are the most overbought in history, P/E ratios are back to normal and hundreds of stocks are trading at single digit P/E’s. Now is not the time to jump ship and make drastic changes.
The case for stocks to rise from here hinges on a slowing jobs market and lower inflation statistics. It is clear to many that inflation has peaked, but it is not dropping fast enough for the Fed. Their “transitory” mistake led to five quarters of rising CPI/inflation data. It could take another five quarters to get back to 2%.
On the positive end, markets sniff this out well before the shoe drops. Nibbling down here on world-class, high free cash flow, low debt level, industry leaders could prove fruitful over the coming years. History says an upturn for stocks should be coming soon. The eventual bottom could be today or a few months from now, but successful investing is all about solid entry points and long-term focus. When fear is rampant and buying stocks feels wrong, it is usually close to a bottom. Inflation peaks provide solid gains, based on history:
As with any historical data, take it with a grain of salt. Never before has the global economy been shut down completely from a virus. Never before have we seen money printing on such a massive scale. Lastly, never before have we seen a Fed this aggressive in such a short time frame. Wonky things have and will continue to happen. The UK intervened because markets were not functioning. I do not expect the Fed to alter their course unless something similar occurs here or the inflation and jobs situations quickly reverse. The Cleveland Fed President said they could keep raising interest rates even if we are in a recession. Times they are a changing. Don’t be surprised if something breaks domestically and the Fed has to reverse course.
The Flash, Ezra Miller, turns 30 today. Fran Drescher turns 65 and Kieran Culkin is now 40.
James Vogt, 610-260-2214