September Investment Comments
Long-term interest rates were choppy with no clear trend in 2023 through the end of July but broke to the upside in August. The 30-year Treasury’s yield recently surpassed its 5-year high of 4.2%, with the 10-year also nudging above 4%. Long-term rates have not traded above these levels for an extended period since the financial crisis of 2008-09. It will be interesting to see whether investors treat this like a ceiling for rates or keep allowing them to rise.
Basic supply and demand for government debt may force a new equilibrium at higher rates, meaning lower bond prices, as the U.S. fiscal deficit will balloon to more than $1.5 trillion in the government’s fiscal year that ends in October. Deficits as a fraction of GDP have averaged 3.6% since 1973. This year’s deficit is likely to be more than 6% of GDP. That is a lot of supply.
There is an old saying in finance, “When the ducks are quacking, feed them.” As long as buyers, both foreign and domestic, maintained a robust appetite for low-yielding debt it made sense to run huge deficits and keep feeding the resulting bonds to the market. We think of our politicians as feckless spendthrifts, but from a certain perspective that is smart business if borrowing is cheap enough. Higher rates are a sign that the ducks are becoming more discriminating. The “bread to quack ratio” is rising.
On the shorter end of the interest rate curve, the Federal Reserve increased its benchmark overnight rate a quarter point to 5.25% on July 27th. The popular view is that rates have likely reached a plateau and will start to come down from here in 2024. That hypothetical interest rate cadence assumes the full effect of recent increases starts restricting measured economic data around the end of this year and that the Fed’s policy goals will thereafter become more balanced between supporting the economy and fighting inflation. The trouble with predicting future interest rates, even one year out, is that future Fed policy will have to jibe with unpredictable future events. In the press conference following the recent rate announcement, reporters repeatedly tried to bait Fed chief Jerome Powell into endorsing the popular view that rates are destined to fall next. Powell only promised that the Fed’s decisions will depend on future economic data. This was tough talk in the context of the press conference. The Open Market Committee’s actual leanings may not be quite as hawkish as Powell seemed to imply. Tough talk is another of the weapons in the Fed’s arsenal. In any event, Powell was wise to remind the market that the future is uncertain.
Speaking of economic data, July’s unemployment rate ticked down to 3.5%. It has remained in a tight range between 3.4% and 3.7% since March. Higher rates have not crimped the jobs market yet. Consumer spending growth has slowed modestly during 2023, as has consumer credit expansion. Between the consumer deleveraging that occurred during the pandemic and the rapid appreciation of house prices, with a resulting positive effect on homeowners’ equity, consumers should remain able to spend. Directionally, however, higher financing rates dampen spending. The car dealership, the appliances showroom, the jeweler’s counter—these are the theaters of the Fed’s war on inflation.
A strong labor market has workers demanding higher wages and, largely, getting what they want. Employers seem willing to compromise, with the notable exception of trucking company Yellow which went out of business after labor negotiations broke down. The United Auto Workers union recently made very ambitious demands on Chrysler’s parent company Stellantis. Besides higher wages, more workers, and more holidays, the union demanded a return to the old days of defined benefit pensions for new hires. That demand sounds particularly unworkable because those pensions already bankrupted the U.S. auto industry once—there is a reason why Chrysler has a foreign parent company—but the fact that the UAW feels emboldened enough to ask says something about how strong they think their position is.
The consumer price index (CPI) rose 0.2% in July, up 3.2% over the past 12 months. That is slightly hotter than June’s 12-month inflation reading of 3.0%. Meanwhile, core inflation, which adjusts out food and energy, rose 4.7% in the 12-months ended July, down from 4.8% in June. The producer price index (PPI) jumped, showing its highest monthly headline reading since January and its highest core reading since February. However, at just 2.7% over the last twelve months, the core PPI remains well below the CPI. While its recent trajectory hints at rising inflation generally, its low level should exert downward pressure on consumer price inflation.
Perhaps the best we can say is that the inflation data is sending mixed signals. It would be very unfortunate to see consumer prices inflect higher from here. On the other hand, because interest rate policy works with a lag it is reasonable to budget for recent increases to exert some incremental downward pressure on inflation in the coming months. It makes sense for the Fed to stand pat in the presence of any further data that could reasonably be interpreted as fluctuation around a lower trajectory.
The Federal Reserve’s increasingly hawkish policy stance is good for the U.S. dollar but negative for real assets priced in dollars. Gold, the champion of real assets, has weakened after failing to hold a late July rally above $2,000 per ounce. Stocks are, for the most part, real assets because the profits companies generate come from real economic production. That is equally true whether a company sells building materials, software, or insurance.
Higher long-term interest rates generally coincide with lower stock valuations, and indeed, the market’s steady uptrend is breaking. The S&P 500’s 5-month streak of gains is in jeopardy in August. Second quarter “earnings season” started on a positive note as investors eagerly, or desperately, chased the market’s biggest winners. That enthusiasm seems to have run its course. If capital gains go on strike then investors may have to get by on dividends for a while.
Opportunities still exist. We note that consumer cyclicals have been weak over the past year, despite the consumer’s ongoing strength and the solid overall economy. In a less cyclical space, medical devices companies generally have not kept up with the strong market this year. The industry has been a long-time darling of growth investors and rarely presents windows of opportunity. As always, investors need to be selective. Profitable growth is the game, and valuations matter. Buy good stuff at fair prices, and you will make money over time.
Miles Putnam, CFA