History lessons
Rates may be resetting higher but that doesn't mean stocks must suffer.
Travel this week took me to State College, a Central Pennsylvania town dominated by Penn State and pumped-up Nittany Lions. Autumn has arrived, along with football season and the gorgeous changing of leaves along the highway. Next stop, Cortland, N.Y., in the Finger Lakes—known as the Crown City, it was named the most affordable small town in the U.S. and is just a 15 minutes’ drive to the state’s largest ski resort, Greek Peak Mountain. Speaking before local businesspeople, our host questioned the odds of an “immaculate landing,” comparing it to Rodney Dangerfield’s “impossible” Triple Lindy dive in the 1986 movie “Back to School.” What history tells us depends on the teller. Jefferies sees a lot of similarity with 1994-5’s sharp rate hikes (a doubling to 6% in 12 months), a cycle that ended with a soft landing. It was one of four periods when Fed rates stayed stable after a period of hikes, with the S&P 500 returning an average 25% over the subsequent 13 months. Gavekal Research thinks the current environment bears a closer resemblance to 2000, when the Fed was tightening, real yields were rising and equities were richly valued after a tech-led bull run. Bulls justified the valuations on three arguments: the Fed would pull off a soft landing; if growth did falter, it would ease aggressively; and new technologies would deliver productivity and profits. The problem: as history shows, soft landings are rare. When activity slowed, the Fed did ease aggressively, but its cuts failed to prop up equities. The new technologies that drove the late-’90s bull did deliver enormous profits, only much, much later. Buying Amazon for $5.30 at the end of ’99 would still have been a painful mistake; a year later it was under $1. So, even if the Fed “put” is real and AI offers boundless potential, investors ignore history lessons at their peril.
Hopefully, the Fed will stop. At 1.1%, the real fed funds rate is decidedly positive and at a level that historically makes economic growth more challenging. Indeed, Empirical Research notes that the current level of real interest rates well exceeds the average of the 2010s. In the 12 months following periods of a rising real rate, Strategas Research says the equity market was up double digits in four of the nine instances and down in the remaining five (just about a toss-up). Deutsche Bank’s research shows that relative to European economies, the U.S. historically has been the most sensitive to broad price spikes, with a recession occurring within three years 77% of the time after inflation has risen by more than 3 percentage points over two years, as it did in 2021-22 (tough odds). Of course, history doesn’t always repeat itself. While higher real yields typically translate to cheaper stock valuations, that hasn’t been the case this year. And despite persistently higher rates, there were zero sell-side 10-year yield forecasts north of 5% for year-end ’23 and Q1 ’24 among the 48 analysts in the regular Bloomberg survey. TrendMacro argues that rising real yields amid falling inflation expectations reflect a restoration of the kind of growth expectations that prevailed before the post-GFC era of “secular stagnation.” It says higher yields almost always have been associated with higher growth expectations, not worries over an impending credit crisis driven by debts and deficits. If the latter were the case, the dollar would be weak and currency hedges gold and bitcoin would be strong. The opposite is true. Interesting times we’re living in.
Stocks’ refusal to trade materially lower despite 10-year yields and WTI crude at new cycle highs indicates the typical late August-September seasonal slide may be ending. Historically that’s followed by Q4 strength. To be sure, the economy’s resilience on a faster-than-expected recovery in business investment and strong private consumption is starting to weaken. And yet, BCA Research calculates 1 trillion still in excess Covid savings, while unemployment claims are being stubbornly low (more below). No wonder Powell said on Wednesday, “I’m sorry, we have to give you guys some pain.’’ But a recession in an election year? I’m betting the administration will do everything it can to prevent such. Strategas notes the unholy trinity of macro investing—a relentless bid to the dollar, rates and oil—historically reveals itself late in a cycle and ends with a lot of pain. On the other hand, conditions for the broader market and its weakest components (Utilities and Consumer Staples currently) are oversold, and sentiment has turned extremely bearish. And September is over! So, while the government closes and unions strike, history tells us to focus on what really matters: interest rates, employment and corporate earnings. October should be interesting. Let’s go!
Positives
- Focus on real interest rates This morning’s personal income/consumer spending/PCE report saw long bonds rally as monthly core PCE rose only 0.1% (this is the Fed’s preferred inflation gauge), while real disposable income fell in August and real consumer spending growth moderated.
- Focus on employment Initial jobless claims edged up less than expected in the latest week and continue to hover at generational lows, with the 4-week moving average at 211k, its lowest since early this year.
- History and math lessons Talk about rich union contracts driving up inflation overlook a few key points, Goldman Sachs says. Union workers mostly are in longer-term contracts, which means they’ve been waiting for a chance to win the same outsized cost-of-living adjustments non-union workers on shorter contracts already got. This makes wage growth for union workers a lagging rather than leading indicator. And the impact should be small because the unionized share of the work force is small (more below).
Negatives
- Is housing just making a bottom? August new home sales plunged, but July’s increase was revised higher, keeping y/y sales up by nearly 6%. Pending home sales plummeted, posting their steepest y/y decline in three months. Meanwhile, Case-Shiller, FHFA and National Association of Realtors price reports were mixed but generally showed prices leveling off at elevated levels, while data from last week showed housing starts declining and permits rising. Finally, weekly mortgage purchase applications fell, paring much of the prior week’s increase. Tight inventories and 7%+ mortgage rates were blamed.
- The consumer reigns a little less supreme Despite upward revisions to incomes on better wages, this week’s big GDP benchmark revisions (covering 2013-23) represented slightly weaker consumer spending over the period. This week’s readings of Conference Board confidence (a 4-month low on worsening expectations) and Michigan sentiment (it rose from the initial estimate but was still below August’s final) sounded cautionary notes on the holiday sales outlook.
- Some D.C. watchers expect a 1- to 2-week shutdown, although … The longest government shutdown, 35 days in December 2018-January 2019, only impacted 20% of the government as numerous appropriation bills already had passed. The Oct. 1-17, 2013, shutdown had a hard catalyst to push lawmakers to reopen: the looming debt-ceiling X-date. This looming shutdown could be quite long, Cowen & Co. says, as there is not an action-forcing policy catalyst that would force lawmakers to find common ground and pass a funding measure.
What else
Union yes! … sort of 55% of full-time employees in the U.S. approve of labor unions, another 32% neither approve nor disapprove and just 13% disapprove, according to a survey by Jefferies. Last year saw the 5th-largest recorded absolute increase in membership (+277k) and the largest since 2007 (+311k) and 2008 (+427k). Still, relative to total employment, union membership has been in a prolonged and steep decline, from a high of 35% in the 1950s to 10% in 2022.
Stronger-for-longer dollar The relative performance of U.S. financial markets and economy vis-à-vis developed markets and much of the world continues to be a tailwind for inflows and dollar strength, but a headwind for earnings and inflation.
Did you know? Bank of America shares that half of Europe’s ski resorts could face snow scarcity because of global warming by the end of the century and that Vulcan 20-20, the world’s most powerful laser can produce a beam a million, billion, billion times brighter than the sun.