No signs of cooling this winter
We hope the end of summer and beginning of fall have been pleasant for you and those close to you.
The third quarter saw the emergence of several market dislocations, driven primarily by the impact of rising interest rates on various parts of the economy. Long-term rates in the US jumped in Q3 and are now higher than they have been in over 15 years. The speed of this move has taken many market participants by surprise. While 2023 has seen the Fed continue to raise short term rates to over 5% (albeit at a slower pace than 2022), the long end of the curve remained well below this level as the market expected rates would go back down in short order once inflation had been tamed. Q3 saw the market shift away from this view to a “higher-for-longer” thesis, where the expectation is that rates may not be cut for several quarters, or at least not until durable progress has been made on inflation or the economy begins showing signs of slowing. This reversal in thinking was evident in the move in the 30-year treasury bond. At the start of Q3, the 30-year was trading at a 3.86% yield (after starting 2023 at 3.975%). By mid-August it had run up to 4.45% and then, after a brief lull at the end of August, ran through 5% by early October, and has traded in that area since.
This move in long-term rates has had a wide-ranging impact on investment decisions across credit and equities markets. For years, investors seeking income had been forced by very low interest rates to look further afield, in riskier segments of the market. Traditional income investors could not rely on savings accounts, treasuries or CDs for meaningful yields, but instead ventured into income securities like preferred stocks, high yield bonds, and dividend-paying equities including REITs and utilities. Now that yields on bonds have returned to meaningful levels, some income investors have switched back to the safety of treasuries and other highly-rated bonds. This move has put selling pressure on income securities — September saw a notable pullback in defensive sectors like utilities, consumer staples and healthcare stocks. We expect this pressure will likely continue until it is evident long term yields have peaked.
Higher interest rates and wage inflation have hit capital intensive industries particularly hard. Renewable energy stocks have seen a sizable sell-off as the market expects higher capital costs, material costs and specialized labor costs to eat into profit margins. While these concerns are warranted, in our view the recent selloff has created opportunities for investors who recognize that the shift from fossil fuels to renewable energy sources is a long term trend.
In addition to the impact on investor sentiment, higher rates have also begun to shift consumer behavior. The average interest rate on credit cards stands at 21%, and consumers have responded by trying to pay down balances. Outstanding consumer credit fell by 3.8% in August. All credit-linked markets have been impacted, including real estate, with existing home sales dropping to levels last seen in 2008 (as housing supply wanes and mortgage rates reach 8%). This change in consumer behavior is what the Fed desired when it started raising rates. The Fed Board of Governors were clear that they were taking this action to staunch inflation and reverse what they saw as an associated asset bubble. The risk to investors is that materially higher rates will stall economic activity in a manner that impacts asset prices dramatically. We believe the Fed is determined to control both inflation and limit asset price speculation. This suggests investors should be cautious and the Federal Reserve (for the first time in about 15 years) does not appear to be supportive of a booming stock market.
Though there have been several important geo-political events over the past several months, in our view, the most consequential to financial markets is the deterioration in the relationship between China and the US. For the past 30 years, the Chinese and US economies have become ever more tightly coupled, with commingled supply chains across every conceivable industry, from iPhones to rubber duckies. The past several years have seen a steady change in the political relationship between the two countries and this has impacted their economic relationship as well. China remains the US’s largest trading partner, and it has developed several industrial specialties that cannot be easily replicated, including battery technology and certain portions of the semiconductor manufacturing industry. Unwinding the close trading relationship between China and the US will take decades, as it has taken decades to develop. The more acute and immediate risk is that political relationships deteriorate enough to drive a trade stoppage. Such an event would reverberate through markets, creating worse supply chain and production challenges than we saw at the beginning of the Covid pandemic. Due to the symbiotic nature of their relationship, neither side necessarily wants this outcome, but there could be circumstances that make it unavoidable (an invasion of Taiwan, for example).
While inflation has trended downward over the course of 2023, it has not dropped at the pace the Fed, policymakers and investors were hoping. We expect inflation will continue its downward trajectory, although the wars in Ukraine and the Middle East will likely place upside pressure in the immediate term (war is often inflationary). We think the Fed may opt to raise short-term rates one more time before the end of the year, depending on how they interpret recent economic data. Either way, we think the Fed is likely at or near the end of their hiking cycle.
Once long term rates do peak and start to reverse lower, we expect to see those asset classes that have been under the most pressure start to outperform: defensive stocks, small cap stocks and intermediate/long term bonds. In recent weeks, commodities, and gold in particular, have seen buying as geopolitical tensions have escalated. We expect gold will continue to perform well if rates fall and the USD weakens. Floating rate bonds, short term treasuries and CDs have been a strong safe haven during recent volatility as yields exceed 5%. We expect these yields to remain compelling until the Fed begins to cut short term rates, likely sometime later in 2024.
Let us know if you would like to discuss any of the above in more detail.
Best,
Louis and Subir