MACRO
Economy remain resilient but majority of economists are expecting things to start turning over. Financial conditions index has declined significantly, driven by higher yields, stronger dollar and increase in oil and energy costs. Discomfort is mostly caused by rates being over 5% and lags in the economy to fully reflect their impact. In addition economists worry about weakening consumer with depleting savings and moving up delinquencies rates. They point out to two main items that can lead to slow down in demand:
- increase in inventories, which reflect slowdown in demand for goods
- high services demand won’t be upheld for much longer as its still propelled by the temporary ‘revenge spending’
Slowdown is what the FED is trying to achieve, but pace and magnitude are critical. If the economy will slow at the pace consistent with the soft landing, than the ‘bad news’ for the economy is a ‘good news’ for an investors. If there will be a sudden slow down in the economic activity due to pressure being to high for the consumer, then ‘bad news’ will be the ‘bad news’ for the investors.
RATES
Long term rates keep marching higher to close the negative gap with the short-term rates. Long duration fixed income investors are suffering huge losses compounding over the last 2 years. Popular long-duration instruments such us TLT ETF (iShares, +20Y maturity FI Fund), lost close to half of their value since the peak in Q3 2020.
Rates remain very volatile as the market tries to find an equilibrium and answer a fundamental question – what is the natural rate of interest under the new monetary regime?
The natural rate of interest is known by economists as r-star. Is is a rate that keeps economy in the equilibrium. In other words, it is a real rate of interest that is neither expansionary nor contractionary, given the full employment. Central banks sets base rates above r-start to cool-off the economy and below r-start to stimulate it. R-star depends on the population’s desire to save and invest, however those are changing and difficult to measure due to impact of the business cycles. This leads to the criticism of r-star as a purely academic or hypothetical measure, rather than one that can be reliably estimated.
Below are FED estimates of r-star using the Laubach-Williams and Holston-Laubach-Williams models.
LW Estimate
Source: NY FED
HLW Estimate
Source: NY FED
Over the last 15 years, in the post GFC regime of low inflation and low interest rates, the expected r-start was merely 0.5%. After adding 2% inflation target, this gives us 2.5% nominal FED funds rate. This explains why the forward interest pricing goes down, as market expects that over time the FED funds rate will gravitate from currently restrictive rate of 5%+, towards the neutral 2.5% rate. Of course this is assuming that r-star or the neutral rate of interest is still 0.5%. As economist are watching rebuts economic growth while the monetary policy is no longer stimulatory, some argue that r-square is actually much higher than 0.5%.
In fact in higher inflation environment such us 1968-2001, when bonds have low but positive correlation with stocks, r-star was somewhere closer to 2% (estimate based on TIPS or real yield on 10Y Treasuries). Now if due to various factors (stickiness of inflation, reduction in benefit of globalization due to decoupling from China and near-shoring and on-shoring) longer-run inflation is closer to 3% rather than 2%, and if r-start is closer to 2% rather than 0.5%, then the current FED funds rate above 5% is only marginally restrictive. This would explain why we did not experience a hard landing, and instead continue to have healthy economic growth.
CREDIT
Both IG and HY doe snot give investors much compensation for taking on the credit risk as spreads remains very modest. On the other hand, resilience of spreads should be look at in the context of changes to the structure of the credit market in the recent years. More HY issuers offering additional security for their debt. The average maturity of new issues has also declined, which reduces required compensation for the default risk.
Over last year companies increased the bridge and mezzanine financing to help them to navigate through changing macro environment. Many expect that currently restrictive environment is temporary and they would be able to refinance over next 36 months at a better rates. If rates will stay higher for much longer, many companies won’t be able to ‘wait-out’ until the restrictive conditions softens and may find themselves exposed to step increase in the cost of capital.
EQUITIES
S&P is closing with 5% loss for the month of September, and a second monthly decline in a row, reducing this year’s gains to 12.3% (total returns). ‘Magnificent 7’ stocks are under pressure and AI rally is loosing its momentum. Index is now 6.5% from the local July high, but it hit a ‘lower low’, and it’s now just 100 points from it’s 200 DMA (at roughly 4,200 points). In addition we are about to begin October, which historically has been a week month for the Equities. From the other hand, some investors are looking past the October, and start to focus on the potential year-end rally, which as per the historical seasonal trends tend to occur in November and December.
Value investors should increase their appetite for the international diversification as the international equities looks particularly attractive from the relative value perspective. The Cyclically Adjusted PE ration (CAPE) for Non-US equities, relative to US equities CAPE is close to historic lows last time seen in 1960’s. This ration has been declining since the GFC, but regime shift to monetary tightening has a potential to stop or even reverse this trend.
At the end of the day no multiples or rates will dictate relative success of US market, but it’s continuous ability to innovate and sustain its technological dominance over the international competitors.