Charts for the Week
October 3, 2022
Q3 | Can't hold its gains
The stock market closed out its third consecutive down quarter last week. The S&P 500 Index gave back all of its summer rally and then some to finish more than 25% off its January 3rd all-time high.
Investor sentiment flipped decidedly negative during the latter half of the quarter. Hopes that a quick Fed pivot away from raising interest rates would revive the epic bull run were dashed as policymakers made clear their intention to keep at it until inflation is tamed.
Across the pond, the market’s reaction to the new prime minister’s economic agenda highlighted that investors no longer even look kindly upon government stimulus. Thus a Fed pivot may not even revive investors' risk appetite at this point.
However, the pessimistic conclusions the herd runs to from here will likely be as improbable as those they are now abandoning. For long-term investors, that would actually be a good thing.
Rate Hikes | Every round goes higher, higher
September 26, 2022
The Federal Reserve hiked the fed funds rate another 0.75% last week with the upper target level now at 3.25%. Policymakers also moved the goalpost for how high they will likely need to raise the fed funds rate to somewhere between 4.5% and 5%.
Despite the Fed raising rates much faster than previous tightening cycles, the real fed funds rate adjusted for inflation remains negative and far below where it has peaked in previous cycles. The latest projections from Fed policymakers indicates that they are aiming to push the real fed funds rate towards 2% which would be above the Fed’s estimate of the current neutral real rate of 0.5% (i.e., the real fed funds rate at which monetary policy is neither accommodative nor restrictive). Based on history, however, capping out a 2% real fed funds rate may still be hopeful thinking.
Credit Cycle | Turning?
September 19, 2022
Typically when the economy starts to weaken the demand for bank loans declines and banks tighten their loan standards. Another indicator that we are likely not in a recession just yet is that demand for bank loans remains generally strong and bank credit continues to expand. However, banks have begun to tighten their lending standards which has historically portended an imminent turn in the credit cycle.
Bank lending is one of the main transmission mechanisms by which monetary policy influences the economy. As the Fed continues to raise interest rates, a reduction in the growth of bank credit is to be expected. And with inflation remaining stubbornly high, the Fed is unlikely to stop tightening policy until both bank loan demand and supply are affected.
Banks | The blessing and curse of higher rates
September 12, 2022
The large wave of deposits that swept over the banking industry over the past two years began to slowly recede in the second quarter. Bank deposits are still more than $3 trillion above their pre-Covid trend level, so banks have not been in a rush to increase the interest they pay on those deposits. This has enabled them to expand their net interest margin quickly.
Bank stocks, however, have not benefited from the rising rate environment and have suffered along with the rest of the market this year. The benefits of higher interest rates have been offset so far by increasing loan loss provisions driven by new accounting rules which require banks to reserve against potential losses more proactively. As concerns of a potential recession have increased, banks have set aside more for potential losses even though current loan delinquencies remain at historically low levels.
Another headwind for banks is that many have added longer-term loans and securities to their balance sheets. Approximately 39.4% of the banking industry’s assets are in maturities greater than three years, which is up from around 35% before the pandemic and less than 30% a decade ago. This raises the potential for realized losses as rates rise and limits how quickly they can take advantage of higher rates.
A return to a more normal interest rate environment should ultimately benefit banks by widening the net interest margin they can earn on their assets. The journey to that point may just be a little bumpy.
Labor Market | Goldilocks August
September 5, 2022
The economy continued to add jobs in August at a healthy rate and drew even more individuals back into the labor force. It was a microcosm of the hoped-for soft landing. If the individuals who left the labor force during the pandemic return, balance could be restored to the labor market and one of the big inflationary pressures on the economy reduced without the need for a decline in overall employment. The seemingly good news did little to cheer the stock market – a sign of the changing market psychology and the new consensus that the Fed is unlikely to be swayed from raising rates by a month or two of good data.
Tea Leaves | Harder to read than usual
August 29, 2022
Last week, the Chairman of the Federal Reserve dashed investors’ hopes that the Fed would soon pivot away from raising interest rates and tightening monetary policy. The challenge of cooling inflation without freezing the economy has been made even more difficult by the fact that the economic dashboard used to guide policy has gone haywire.
The combination of a global pandemic and a flood of government stimulus has reshaped economic life to a degree that makes it hard to gauge the health of the economy with an unusual amount of yin and yang present in the available economic data. For example, as the inflation-adjusted Gross Domestic Product has contracted for two consecutive quarters and fallen further below its pre-Covid trend, the real Gross Domestic Income (which should equal GDP) has continued to increase and remains slightly above trend. Similarly, while labor force participation has been drifting lower in recent months and roughly two million individuals still haven’t returned to the labor force, the job market otherwise seems to be in robust health with the unemployment rate at the lowest level in decades. And at the same time that labor productivity has recorded its largest year-over-year decline on record and labor costs are rising, corporate profit margins remain near all-time highs. The yin suggests that economic slack is building in the economy that should bring down inflation and let the Fed step off the brakes before long; the yang implies the Fed still has a lot more braking to do.
The economic data may someday be revised to be more congruent, but for now the tea leaves do not offer a clear picture. Much as they did in the muddle of the pandemic when Fed policymakers asserted that they would err on the side of keeping monetary policy accommodative until inflation was clearly a problem, policymakers have made even more clear that they will now err on the side of tightening monetary policy until inflation is well under control. They were true to their word last year. Investors are starting to glom on to the possibility that they might actually mean what they say this time as well.
The Fed's QT | About to pick up the pace
August 22, 2022
As part of its response to the economic disruptions caused by the Covid pandemic, the Federal Reserve purchased over $4.6 trillion in US Treasury debt and mortgage-backed securities (MBS) which more than doubled the size of its balance sheet to nearly $9 trillion. In June the Fed began to slowly shift from “quantitative easing” to “quantitative tightening”; although, its holdings of MBS have yet to decline as planned. Next month the Fed has indicated that it will double the pace at which it lets Treasurys and MBS run off its balance sheet to an annualized rate of $1.14 trillion (~13% of the Fed’s assets). At that rate, it would still take several years to unwind the extraordinary policy moves of the past two years and even longer to completely unwind the whole era of quantitative easing. For now the Fed is reducing its assets by simply not reinvesting maturing securities. To quickly shrink its balance sheet, it would need to sell some securities, which it is probably not eager to do as it would be at a loss that would raise some uncomfortable questions. Nevertheless, while the pace may be constrained, the increased monetary tightening will likely still be a headwind for stocks, which saw major indexes fail to rally past their 200-day moving averages last week. Quantitative easing was always more a psychological nudge for investors to take on more risk than a mechanical process leading to higher stock prices. In the same fashion, the opposite narrative of a Fed removing the proverbial punchbowl could capture investors' imaginations in a negative way as the pace of quantitative tightening picks up in the coming months, especially when coupled with continued increases in the Fed's target federal funds interest rate.
Forecasting Inflation | Not for the faint-hearted
August 15, 2022
The Consumer Price Index was unchanged in July offering a welcome reprieve from recent high inflation thanks largely to a pullback in energy prices. Despite failing to foresee the persistent runup in inflation, professional forecasters surveyed by the Philadelphia Fed continue to project inflation to decline rather rapidly over the next year without a recession, which would be unusual. The financial markets are certainly banking heavily on that happy outcome, which investors hope will also mean the Federal Reserve will soon stop raising interest rates. However, even if the prognosticators are now at least directionally correct in their inflation predictions, the Federal Reserve will likely still have to raise interest rates more than is currently priced into market valuations if policymakers are serious (as they claim they are) about pushing real short-term interest rates (i.e., the nominal interest rate minus inflation) back into positive territory.
Labor Market | Fully recovered?
August 8, 2022
The job market remained strong in July with the unemployment rate dipping to 3.5% and more than 500,000 new jobs being created, which pushed total payrolls above their pre-Covid level (assuming no future downward revisions to the estimated payrolls). Nevertheless, the labor force participation rate continued to trend the wrong direction as more men left the workforce. One of the reasons that the Fed kept monetary policy overly accommodative for so long was the desire to keep the economy humming until all those who had left the workforce returned. The surge in inflation derailed that plan. The changes to the labor market may also be less transitory than the Fed initially anticipated. Demographics were already expected to naturally pull the participation rate down towards 60% over the next decade, but the pandemic may have fast forwarded that adjustment slightly as individuals have chosen to retire early. The labor market also remains tight because of both a continued high level of workers out on sick leave increasing the need for workers and a slower pace of immigration decreasing the size of the labor pool. At this point, it appears the demand for labor has fully recovered from the Covid recession, but the supply remains constrained, which should benefit workers even as economic growth slows.
August 1, 2022
Recession | Increasingly likely if not yet
The latest estimate of Gross Domestic Product indicated that the US economy continued to shrink for the second consecutive quarter – the classic Econ 101 definition of a recession. We won’t know for several months whether the cognoscenti at the National Bureau of Economic Research will officially pronounce that a recession has begun. The strength of the labor market and continued growth in personal consumption suggests the economy has not yet entered “a significant decline in economic activity that is spread across the economy.” Nevertheless, the odds of a recession seem to be growing every day. The bond market’s recession indicator of an inverted yield curve continues to suggest an economic downturn is on the horizon as the yield on the 10-year Treasury note has fallen well below the 2-year yield and the supposedly more predictive 10-year to 3-month spread is poised to flip negative in the coming weeks. Given the current down-is-up psychology of the market, the weakness in the economy sent stocks higher in July on the hope that the Fed will soon stop raising interest rates and may even start to lower them early next year. That is logical given what investors experienced after the brief market sell-offs in 2018 and 2020. The drawdowns in 2000-2002 and 2007-2009 are less promising historical comparisons for investors when it comes to gauging the Fed's ability to stop a bear market -- and then there's the prevailing high inflation which may keep the Fed from pivoting altogether.
Value vs Growth | The tortoise is still well positioned
July 25, 2022
Since the end of November, the Russell 1000 Value Index has outperformed the Russell 1000 Growth Index by roughly 17%. The rotation into stocks with valuations based more on current earnings than high expectations for future growth actually began back in August 2020, but the extra dose of excessive government stimulus provided in 2021 gave growth stocks one last run at glory. While some growth stocks have already imploded spectacularly, investors have not abandoned their speculative excesses as quickly as they did after the market peak in 2000. Growth stocks have even regained some ground in the past couple of months on a relative basis. Three decades of increasingly investor-friendly monetary policy culminated in an ideal environment for growth stocks and has conditioned investors to expect more, especially after the unprecedented response by the Fed to the pandemic. Nevertheless, the Fed will be hard pressed to reverse course while inflation is running hot. Even when it does, that may not bring back the good old days for growth stocks; the Fed cut interest rates throughout the long bear market from 2000 to 2002 without reigniting a love for internet stocks. Value stocks thus still seem well positioned to continue to build on their record of outperforming over the long run.
Peak Inflation | Someday...
July 18, 2022
Someday inflation will surprise on the low side, but that day did not come last week with the latest inflation report. The Consumer Price Index (CPI) was 9.1% higher in June than it was a year ago with food and energy prices continuing to push inflation higher. There are glimmers of hope that prices for those volatile items will at least plateau at current high levels if not decline as gas prices have done in recent weeks. Core inflation excluding food and energy also slowed ever so slightly as the price increases for goods declined by a decent amount for the fourth month in a row. Even if inflation as measured by the CPI does begin to moderate, it is likely to remain stubbornly high in the coming months as the estimate for the cost of housing, which makes up 30% of the CPI, continues to tick higher. Some solace has been taken over the past year in the fact that at least inflation isn’t as bad as it was in the 1970s; however, a recent academic paper - which attempted to reconstruct historical inflation numbers using a methodology and weights similar to what the government uses to calculate the CPI now - found that the current inflation rate is much more commensurate with the worst inflation rates seen during that period than the official inflation data suggests. Unlike the 1970s, what we have not had thus far is the years of high inflation that can reshape the expectations of workers, consumers and investors about future long-term inflation. This can be clearly seen in the financial markets in a number of indicators, including the trailing real earnings yield for the S&P 500 which is around negative 4% at the moment even after the sell-off this year – a level far below those seen in the 1970s and in line with a belief that inflation will decline back to around 2% before long.
Labor Market | Supply still down, demand still up
July 11, 2022
Another strong jobs report reduced concerns that the US is already slipping into a recession. The unemployment rate stayed low at 3.6% as employers added 372,000 to their payrolls in June. While the rebound in the job market over the past two years has been impressive, the total number of individuals employed and the percentage of individuals participating in the labor market (i.e., the percentage either employed or looking for work) are still below where they were before the pandemic. The demographics of the country are naturally pulling the participation rate down, but upwards of two million individuals are still seemingly missing from the labor force, which has put upward pressure on wages. A tight labor market that is adding to inflationary pressures which are in turn devouring all of the wage gains provides additional support for the Fed to push forward with all deliberate speed in raising interest rates to rein in rising prices. Market participants are now expecting the Fed to increase its target overnight interest rate to 3.75% by the end of the year. The targeted upper level for the Fed funds rate hasn't been above 2.5% since early 2008.
CFOs | Everything is awesome… for us (we hope)
July 4, 2022
A recent survey showed business leaders maintaining relatively high confidence in their own operations despite waning optimism about the broader economy. That sentiment is growing as incoming data indicate economic activity is continuing to slow, raising the specter of a second consecutive quarter of negative GDP growth. Investors sentiment also soured in the first half of the year with the stock market turning in its worse performance since 1970, with the S&P 500 Index down more than 20%. Over the past seven decades, the two other previous big market declines through June were followed by big rebounds in the second half of the year; however, of the seven first half declines greater than 10%, four saw the market continue to fall further in the second half of the year. All of which is to say, guessing the short-term direction of the market is as always just that – a guess. But a strong second-half rebound would likely require the optimism of business leaders and analysts, who continue to expect bumper corporate profits in the coming quarters, to be borne out.
Sources: YCharts, https://www.spglobal.com/spdji/en/indices/equity/sp-500, https://www.richmondfed.org/research/national_economy/cfo_survey, Federal Reserve, https://www.atlantafed.org/cqer/research/gdpnow.aspx, AOWM calculations
Stocks | Fundamentals less volatile than the market
June 27, 2022
Unless speculating on being able to sell to someone else in the near future at a higher price, investors buy a stock to own a share of a company’s future earnings and dividends. Those earnings and dividends represent the real wealth for long-term investors, and the goods news is that, for a diversified portfolio of stocks, those fundamentals are far less volatile than the price at which a stock gets traded back and forth. While the market can swing wildly year to year, the cumulative earnings and dividends produced over several years by corporate America have historically grown within a fairly tight and predictable range. There is no guarantee that will continue which is why stocks offer a return premium relative to safer fixed income investments. Nevertheless, keeping an eye on the long-term growth in earnings and dividends can help keep investors from becoming too euphoric or despondent with the shifting market moods. At the extremes, things are unlikely to be as wonderful or dire as they seem.
Sources: http://www.econ.yale.edu/~shiller/data.htm, AOWM calculations
The Fed | Oops, I did it again
June 20, 2022
The Federal Reserve increased its target overnight Fed Funds interest rate by 0.75% last week - the largest increase after a FOMC meeting since 1994. Policymakers once again had to admit to misjudging inflation as they continue to try to catch up with rising prices. And the Fed once again increased its projections for how high it will have to raise the Fed Funds rate (from 2.8% to 3.8%) and the real Fed Funds rate (from 0.5% to 1.4%) in order to get inflation under control. While the Fed’s outlook for economic growth has declined, policymakers still expect unemployment to remain low and the economy to continue expanding largely in line with its long-term potential slightly below 2% per year. Even though the Fed has repeatedly underestimated inflation over the past year, its projected “soft landing” still requires inflation to retreat towards 2% while monetary policy remains accommodative by historical standards and the economy avoids a recession. Given the Fed’s recent forecasting performance, investors took cold comfort in its latest outlook. A swift, broad sell-off in stocks that began on June 8 has sent the market firmly into bear territory. While rallies will come and go, a new bull market may not be born until the Fed gets ahead of the curve with inflation and stops playing games with investors’ hearts.
Sources: https://fred.stlouisfed.org/, Federal Reserve Board
Inflation | Deflating sentiment
June 13, 2022
The year-over-year increase in consumer prices hit a four-decade high of 8.6% in May. Investors and economists had hoped and expected that inflation had peaked back in March; the failure for it do so weighed on the stock market at the end of last week sending it back towards lows for the year. Inflation has also depressed consumer sentiment as measured by the University of Michigan’s Surveys of Consumers. The preliminary survey results for June showed the University of Michigan consumer sentiment index dropping to a record low. The previous lowest point was in 1980 when inflation was over 14%, the economy was in recession and the S&P 500 was trading at just seven times earnings. Before this year, investor sentiment had remained unusually buoyant in the face of waning consumer sentiment, but no longer. While investors still expect the Fed to keep inflation from becoming a long-term problem, expectations for what it will take to do that keep going up.
Sources: https://fred.stlouisfed.org/, YCharts, BLS, Federal Reserve Board, https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
Investors | Nervous but not scared
June 6, 2022
Various recent surveys have shown investors growing increasingly concerned about the short-term outlook for the stock market. Respondents to the recent Conference Board Consumer Confidence Survey offered their most negative outlook for stocks in nearly a decade. Similarly, a Gallup Poll in April recorded the lowest percentage since 2012 of stock owners who view stocks as the best long-term investment (24% indicted stocks while the percent picking real estate as the best long-term investment jumped to 49%). The weekly investor sentiment survey published by the American Association of Individual Investors (AAII) also indicates that investors this year have been about as bearish as they’ve ever been over the survey’s thirty-five year history. Such growing pessimism could be seen as a counterintuitively positive sign for stocks in the spirit of the adage that it is best to be greedy when others are fearful. However, even though some market-based sentiment indicators – such as the VIX index, the put-to-call ratio and the change in margin debt outstanding – have also trended in a bearish direction, they remain below levels typically seen at market bottoms, and investors’ allocation to equities remain at a historically high level. So far, investors appear to be nervous but not scared. Thus while having a cautious outlook for the market is no longer contrarian, the caution has yet to rise to the level of being a contrarian indicator itself.
Sources: https://fred.stlouisfed.org/, YCharts, https://news.gallup.com/poll/1711/stock-market.aspx, https://www.aaii.com/sentimentsurvey, https://www.aaii.com/assetallocationsurvey, https://www.cboe.com/us/options/market_statistics/daily/, https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics
Personal Savings | Large but predictable swings
May 30, 2022
The personal savings rate as a percent of disposable income fell to 4.4% in April, the lowest since 2008. The falling savings rate and increasing level of credit card debt has raised concerns that the consumer may be maxed out of spending power in the face of high inflation and declining real wages. From a macro level, however, the decline in savings is predictable as the federal budget deficit has fallen back to a mere $1.2 trillion over the past twelve months. If the government isn’t dissaving as much, there is less need for the private sector to save, especially as foreign savings flowing into the US remains strong. And thanks to the massive Covid-19 stimulus, individuals in aggregate have saved over $2 trillion more than they likely otherwise would have over the past two years and corporations have benefited from juiced profits, both of which should provide some cushion for the economy in the coming quarters. Nevertheless, the recent surge in consumer prices and build-up of excesses in the financial markets are reminders that large government stimulus comes with trade-offs - there is no free lunch.
Sources: https://fred.stlouisfed.org/, BEA, AOWM calculation
Outlook for Profits | The Analysts vs The Crowd
May 23, 2022
Companies enjoyed record profits last year, and stock analysts remain generally optimistic for earnings to remain robust with historically high profit margins and returns on equity expected to persist. If the analysts are right, stock valuations are starting to look attractive or at least reasonable; the crowd still seems unconvinced. The collective wisdom of investors certainly correctly anticipated the rapid, record-setting rebound in earnings after the initial Covid-19 shock; however, as the crowd is prone to do, a short-term trend was turned into a dubious long-term assumption leading to some market mania. A reversion to the mean for profits and the market is a reasonable outlook for investors to adopt, and the analysts may not be far behind. The good news for the broader economy is this need not imply a recession as corporate profits often take a breather in the middle of an economic expansion.
Sources: https://fred.stlouisfed.org/, https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview, AOWM calculation
The Bottom | Are we there yet?
May 16, 2022
Despite a strong rally on Friday, the stock market continued to decline last week. Broad market indexes have come close but have yet to fall 20% into fabled bear market territory. While valuations based on forecasted earnings have come down to more reasonable levels, they remain elevated if high profit margins are not sustained. As investors adjust to rising interest rates and a Fed that seems impervious to their pain, the odds of a prolonged period of higher-than-normal market volatility are increasing. If a bear market is upon us, history suggests the selling pressure will subside when the Fed is near the end of an easing cycle (a tightening cycle is just commencing), the market has fallen 25% below its 200-day moving average (currently around 10%), and expected market volatility has increased above 40% (now less than 30%). History also suggests it will be a long and winding road. All that said, the recent past has highlighted that history is an imperfect guide, and we may merely be in the midst of a market correction with new highs not far off. However, the rising probability of a more significant drawdown warrants taking measured steps to mitigate the downside risk.
Sources: https://fred.stlouisfed.org/, YCharts, AOWM calculation
TIPS | Diversification for an uncertain time
May 9, 2022
The inflation expectations reflected in Treasury Inflation-Protected Securities (TIPS) have trended higher over the past year along with realized inflation. Based on TIPS yields compared to nominal Treasury bond yields, investors are expecting inflation to decelerate from over 8% to below 5% over the next year and then continue to moderate back to around 2.5% after three years. However, TIPS investors don’t have a crystal ball and likely suffer the same recency bias we all do as TIPS breakeven inflation rates have historically tracked closely with realized inflation. Until experience proves otherwise, TIPS are likely to reflect the recent past where inflation is a problem now but won’t be for long. Investors will benefit the most from having an allocation to TIPS if we are entering a period of low economic growth and high inflation (as last week’s economic reports of poor productivity growth and a tight labor market suggest is a possibility). On the other hand, if the Fed is intent on driving inflation back down to 2% as quickly as possible, nominal Treasury bonds will likely outperform TIPS over the next few years as real inflation-adjusted interest rates rise and inflation falls. Whatever the future may hold, TIPS provide good diversifications benefits for investors at a time of heightened macroeconomic uncertainty.
Sources: https://fred.stlouisfed.org/, US Treasury Department, AOW calculation
GDP | False negative?
May 2, 2022
The US economy unexpectedly contracted in the first quarter of the year. The main driver of the slight 0.36% decline (1.4% annualized) was the increasing trade deficit. Imports have returned to their pre-Covid trend thanks to strong domestic demand, but exports have continued to languish. The consensus view is that the economy is not falling into a recession as the consumer who drives the bulk of economic activity continues to spend at a healthy clip with a rebound in the consumption of services offsetting slowing demand for goods. Neither the decline in GDP nor the recent rumbles through the stock market have significantly changed investors’ expectations for substantial interest rate hikes by the Federal Reserve over the next year. While it is unusual for the Fed to be embarking on a tightening cycle on the heels of a negative GDP print, a significant rise in unemployment may be the only thing that would give the Fed pause until inflation retreats -- and the labor market is still very strong by almost every measure.
Soft Landings | Possible, but not probable
April 25, 2022
Market expectations for how quickly the Federal Reserve will raise rates continued to ratchet higher last week with the Fed now anticipated to increase the overnight federal funds rate by 0.50% at its next meeting in early May. The last time the Fed increased its target interest rate by that much in one meeting was May of 2000. Investors are now pricing in short-term rates to reach 2% by the end of July, 3% by the end of the year and 3.5% by the middle of next year. The last time the Fed increased rates that quickly was back in 1994 when it increased the federal funds rate from 3% to 6% in one year and pulled off the fabled soft landing of cooling inflation without causing a recession. The recent volatility in the stock market exhibits growing concerns that policymakers won’t be so successful this time, and history suggests those concerns are valid. Of the thirteen monetary tightening cycles that have occurred over the past seventy years, only three have not ended in a recession. Hard landings are the norm. Adding to the challenge this time is how far behind the curve the Fed appears to be with the Fed Funds rate far below an uncomfortably high rate of inflation.
Sources: YCharts, CME Group, https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
Inflation | Hope springs eternal
April 18, 2022
Year-over-year inflation recorded another forty-year high last week with prices up 8.5% from March of last year. With the month-over-month core inflation excluding food and energy down for the second month in a row, there is a consensus view that March will represent peak inflation which is expected to retreat over the remainder of the year. That would be welcome as inflation has weighed down real wages and consumption over the past year. Barring more unwelcome surprises, the math logically points to a slow down in the rate of price increases from here. Whether inflation will retreat all the way to a stable 2% without a fight is less certain. The last mile back to price stability may be the hardest.
Bond Market | Sell-off continues
April 11, 2022
The sell-off in the bond market continued last week as comments by Federal Reserve officials and minutes from their last policy meeting increased expectations for interest rates to be higher sooner. The 10-year Treasury rate closed last week at 2.72% and has now increased by 2.2 percentage points from the low of 0.52% in 2020. The current decline in the bond market is in the same league as the pain Paul Volker inflicted in the early 1980s in his efforts to reign in double-digit inflation. Interest rates increased much more back then with the 10-year Treasury yield maxing out at 15.8% in 1981; however, the price declines were offset to some degree by the high interest earned. With interest rates still so low, the interest earn these days does little to mitigate the decline in bond prices. The move in the long-term yield did help to fix the ominous inverted yield curve at least in part with the spread between the 2-year and 10-year Treasury yields quickly moving back into positive territory. The adjustment to a normal rate environment is likely not done yet as a healthy economy would see the 10-year yield regularly trafficking between 3% and 4% with inflation back around 2%. Thus the bond market sell-off could ultimately exceed the roughly 20% decline seen in 1980. Nevertheless, most of the damage is probably already done -- unless inflation continues to romp wildly.
Sources: https://fred.stlouisfed.org/, Federal Reserve, US Treasury, AOWM calculations
Yield Curve | Flashing yellow...
April 4, 2022
Interest rates are marching higher. The 10-year Treasury yield has for the moment broken through the upper bound of its four-decade long downtrend while short-term rates have risen even more quickly. The yield on Treasury debt maturing in two years rose above longer maturities last week for the first time since 2019. The so-called inverted yield curve - where short-term yields rise above long-term yields - raises the specter of economic turbulence ahead as a yield curve inversion has preceded every recession since 1969. The Fed still has to raise ultra-short rates as expected for the full yield curve to invert, but the bond market is now projecting a bumpy ride if it does. The mega downtrend in interest rates may not be over yet, if tightening monetary policy to a relatively neutral level really is too much for the economy to handle well. It would actually be a healthy sign for long-term rates to continue marching a little higher without inducing fears of an apocalypse.
Sources: https://fred.stlouisfed.org/, Federal Reserve, US Treasury
The Trend | Still a friend?
March 28, 2022
Stocks have rallied nicely the past couple of weeks to stem their losses for the year and enable the S&P 500 Index to notch the highest 2-year return in its 65-year history. The broader US equity market, as measured by the Russell 3000 Index, is now bumping up against its 200-day moving average which it fell below earlier this year for the first time since the early days of the Covid-19 pandemic. The coming weeks will be telling as to whether investors have gone from “buying the dip” to “selling the rally” with the long-run moving averages serving as potential trading signals. If we have embarked on a classical prolonged bear market downturn, it will likely be punctuated with several strong rallies. During the market decline after the tech bubble in the late 1990s, there were three rallies of 20% or more interspersed as the market proceeded to lose half its value over the course of two and half years. While the near-term direction of the stock market is always an open question, the ultimate historical trend in the market remains the friend of investors with a long-term perspective.
Sources: S&P, YCharts, http://www.econ.yale.edu/~shiller/data.htm, AOWM calculations, The S&P 500 Index, formerly called the Composite Index (and later the Standard & Poor’s Composite Index), was first launched on a small scale in 1923. It began tracking 90 stocks in 1926 and expanded to 500 in 1957. Total return graphs are charted on log scales.
The Fed | Still just trying to catch up with inflation
March 21, 2022
Last week, the Federal Reserve raised its target overnight Fed Funds interest rate by 0.25% and projected six more rate increases this year as policymakers sped up their plans for raising nominal interest rates. Last September, they were looking to increase the Fed Funds rate to just 0.30% this year, and now it's projected to be 1.9% by December. This would seem to be a significant tightening of monetary policy; however, after adjusting for expected inflation (as forecasted by those same Fed policymakers), the real Fed Funds rate is actually projected to be lower this year than it was forecasted to be a year ago when the Fed was publicly committed to the notion that the pandemic-induced burst in inflation would be brief and transitory. Despite Fed officials ramping up their public concern about inflation and rhetorical commitment to price stability, the numbers paint a picture of a Fed that is still holding fast to the belief that inflation will naturally retreat without a significant tightening of monetary policy or slowing of the economy. The stock market cheered the relatively unchanged outlook for real interest rates last week. If the Fed’s implicit faith in benign inflation ultimately proves to be misplaced, the cheering likely won’t last.
Sources: https://fred.stlouisfed.org/, Federal Reserve
World Trade | Already past peak globalization?
March 14, 2022
While Americans are importing a record of amount goods straining supply chains and pushing the US trade deficit further into the red, overall world trade has been relatively stagnant since 2008 and declining as a percentage of the global economy. The pandemic and now the war in Ukraine have highlighted how interlinked the world economies have become; at the same time, those events have led many to question the wisdom of that level of interdependence. Global trust and cooperation between developed and developing nations appears to be waning and with it one of the big deflationary forces that has helped to keep inflation low, just as inflation is hitting its highest levels in four decades. The rise in consumer prices is still likely to slow this year, but keeping inflation low and stable is becoming increasingly more challenging for policymakers.
Energy Prices | Adding to the wall of worry
March 7, 2022
Following the Russian invasion of Ukraine, the price of oil has spiked to its highest level since 2008. Prices at the pump have also increased with the average price of gasoline topping $4 per gallon for the first time since 2011. Gas prices were supposed to be one of those transitory items that would enable inflation to cool naturally; however, as geopolitical events have continued to push energy prices higher and raised doubts about how aggressively the Fed can raise interest rates in the current environment, inflation expectations have begun to climb again. Investors face an increasing wall of worry which they have overcome time and time again in the past -- although, starting with historically high asset valuations adds another layer of difficulty to the task in the short run.
February 28, 2022
Events | Predictably unpredictable
Stock markets around the globe became increasingly volatile last week following the Russian invasion of Ukraine. On Thursday morning, the S&P 500 Index was down more than 5% and the Nasdaq more than 7% from the close the previous Friday, but from there stocks rallied strongly to end up around 1% for the week. Such spikes in short-term volatility are not unusual around major turning points in the market – both good and bad. While the intraday swings in sentiment last week were above average, they were still relatively tame given the potential Pandora's box that has been opened in Eastern Europe and far from the swings seen at the beginning of the Covid-19 pandemic, during the financial meltdown in the fall of 2008, or over the course of the bursting tech bubble at the beginning of the century. Even if the war in Ukraine is mercifully brought to a quick and good conclusion, increased market volatility is likely here to stay as the Federal Reserve tightens monetary policy to stem inflation. Over the past two years, many stocks have been bid up to offer minimal potential future returns for the risk being assumed by investors. Some of those high flyers had already fallen a long way back towards earth before last week. Recent global events are just another reminder that investors are well served to bake in a margin of safety and require an absolute potential return that compensates for the predictably unpredictable.
February 21, 2022
Housing Market | Weathering higher mortgage rates
The average 30-year mortgage interest rate has jumped nearly one percentage point over the past couple of months, increasing the cost of a new monthly mortgage payment by more than 11%. Mortgage rates are now in line with where they have been over the past decade; whether they continue to head higher will depend largely on whether investors continue to believe inflation will be brought swiftly under control. So far the higher rates have not significantly slowed the hot housing market. The increase in rates may have actually pulled some demand forward as individuals rush to buy a home in fear that rates will only head higher. Average rents increasing by more than 15% over the past year have likely also provided further incentive for individuals to lock in a fixed mortgage payment and for investors to seek out rental investments. The strong housing demand has met a historically low supply of existing homes for sale, which has combined to send home prices up over 30% the past two years. New home construction is picking up to meet the demand but has been constrained by supply bottlenecks. Higher mortgage rates and ultimately increasing supply will likely limit further price increases in the near term with inflation doing the primary work of reducing any recent excesses.
Sources: YCharts, National Association of Realtors, US Census Bureau, Redfin (https://www.redfin.com/news/investor-home-purchases-q4-2021/), https://fred.stlouisfed.org/
February 14, 2022
Inflation | Investors keeping the faith
Inflation ground stubbornly higher in January with the Consumer Price Index up 7.5% over the past year. While the Federal Reserve is keeping monetary policy dialed to extremely accommodative for one more month in the face of the highest inflation in four decades, investors have so far kept the faith that policymakers have everything under control. Short-term interest rates have shot up as investors expect the Fed will have to raise its target overnight interest rate sooner and faster than thought just a few weeks ago; however, the bond market still paints a picture of the future where inflation is brought quickly under control, interest rates remain historically low and the threat of a recession remains beyond the horizon. The stock market has similarly experienced increased volatility without abandoning a generally positive outlook for what is to come. The wisdom of the crowd should be hedged but not blithely dismissed.
February 7, 2022
Federal Debt | Bad but not that bad... yet
Last week the gross debt of the US federal government reached $30 trillion, having increased by $6.8 trillion over the past two years. The amount of privately held federal debt is significantly less at $17.7 trillion as $6.5 trillion of the gross number is intragovernmental debt the federal government owes itself and $5.7 trillion is held by the Federal Reserve. As the Fed works to shrink its balance sheet, privately held federal debt will trend towards 100% of GDP even if the growth of the federal debt were to slow to be in line with the growth of the economy. That level of public debt does not raise as much concern as it used to, though that may change if interest rates continue to increase as well.
January 31, 2022
Economic Growth | Less than meets the eye
The US economy grew 5.5% in 2021 - the fastest rate of growth since 1984. In the last three months of the year, the economy appeared to have bounced back strongly from the slowdown in the third quarter with annualized growth of 6.9%. However, excluding changes in inventories, economic growth for the fourth quarter was just 2% as personal consumer spending slowed significantly in November and December. After adjusting for inflation, personal consumption - which makes up 70% of the economy - is now back below the trend it was on before the pandemic. Going forward, the Omicron variant and the end of direct fiscal stimulus payments will likely continue to weigh on economic growth for at least the first part of the new year, and there is an increasing possibility that growth for both the economy and corporate profits may disappoint expectations in 2022.
Sources: BEA, https://fred.stlouisfed.org/, https://www.atlantafed.org/cqer/research/gdpnow.aspx, AOWM calcualtions
January 24, 2022
Stocks | Inflation is not your friend
After sailing along relatively smoothly for nearly 22 months, the stock market has begun to experience some rougher seas. The S&P 500 Index fell below its 200-day moving average on Friday for the first time since the end of June 2020 and has had the largest pullback in over a year after a very placid 2021. At just 8.3% off its all-time high closing price reached on the first trading day of 2022, the recent market action is indicative of the typical level of volatility historically associated with equities, though it is perhaps more than investors have been recently lulled into expecting. While there have been signs of increasing risk aversion under the surface, increased investor concerns about high inflation and rising interest rates have begun to weigh on some of the largest company valuations that have kept the headline indexes moving higher the past few months. A Federal Reserve that is more aggressive about keeping inflation in check may not make investors happy in the short term, but they would like the return of persistent high inflation even less as it would likely reduce valuation multiples significantly more than profits could be boosted with higher prices.
January 17, 2022
Inflation | Things are so expensive
Inflation remained non-transitorily high in December with the Consumer Price Index (CPI) up 7% compared to a year ago. Prices for goods have played the unusual role of pulling the overall CPI higher over the past year. The cost of goods excluding food and energy had remained largely unchanged for more than two decades leading up to the pandemic which created a perfect storm of surging demand and supply constraints for things. Goods inflation should moderate as the disruptions caused by Covid-19 subside. Whether goods will return to serving as a disinflationary anchor to overall inflation is less certain. There are also building price pressures for services and energy, all of which increases the probability that inflation will stay higher for longer than policymakers had hoped or expected and force them to push interest rates up higher sooner than hoped or expected.
Sources: BLS, https://fred.stlouisfed.org/
January 10, 2022
Interest Rates | Déjà vu all over again
Like last year, interest rates began the new year by spiking higher. The initial jump in rates was supported by news that suggested the Federal Reserve really is serious about speeding up the normalization of monetary policy as well as a jobs report showing the unemployment rate dipping to 3.9% in December. Also similar to last year, the increase in interest rates sent rumbles through growth stocks whose high valuations are partly dependent on rock-bottom interest rates. The 10-year Treasury yield is now testing the levels it reached last spring when the consensus expectation was for rates to continue heading higher -- which is the logical consensus again today with inflation running at nearly 7% and the Fed supposedly on the verge of ceasing its bond buying. Time will tell. The persistent, four-decade downtrend in interest rates has repeatedly foiled expectations for higher rates. If the 10-year Treasury yield rises towards 2.5% by the end of this year, that long trend may actually be broken. It would also be the first time since the 1950s that long-term Treasury securities will have suffered negative returns in back-to-back calendar years.
Sources: YCharts, US Treasury, http://www.econ.yale.edu/~shiller/data.htm, S&P, AOWM calculations
January 3, 2022
The Market | An enigma wrapped in a conundrum
At the start of 2022, the US stock market is simultaneously expensive on an absolute basis and cheap relative to risk-free US Treasury debt. At its root, the value of any financial asset is a summation of the cash flows investors collectively expect to receive in the future for holding the asset discounted by the return that investors expect to receive for risking cash now to buy it. A valuation model that discounts dividends (i.e., the actual cash investors receive) is not sophisticated, but it requires only one heroic assumption – the future growth rate of dividends – to lend insight into the current value of the market. Decades of data show that over thirty to forty-year periods the nominal growth rate of dividends for the market as measured by the S&P 500 Index has not oscillated greatly despite very different economic and inflation environments and the increasing prevalence of stock repurchases by companies. If the growth rate of dividends over long periods is fairly stable, then the current dividend yield becomes a more meaningful valuation metric that avoids debates about accounting earnings but tells the same story – the market is expensive and a swift return to more historical levels would be unpleasant. At the same time, stocks have rarely offered such a return premium relative to Treasury debt, which offers some hope that interest rates could rise without tanking the stock market.
Sources: http://www.econ.yale.edu/~shiller/data.htm, S&P, AOWM calculations
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