Have interest rates in the US peaked? And is the worst of stock market volatility, driven by sharply rising yields in the past three months, behind us? The answer to the first question is “Yes, probably” while our prognosis for the second is “No, unlikely”.
For starters, we think markets are overly optimistic in expecting the US Federal Reserve to cut interest rates, as early as May-June 2024, just as they were earlier this year in March, and throughout 2022 (all proven to be premature). And, more importantly, we think investors are underappreciating the impact of the end of the secular decline in interest rates, which has prevailed for the past 40 years or so.
It is probably hard for a whole generation of investors and analysts to imagine a world where 10-year US Treasury yields stay at around 4% to 5% (perhaps even higher) for an extended period of time. But there is certainly a case to be made for interest rates to remain higher than they have been in the past decade and a half since the global financial crisis (GFC).
Higher borrowing costs must eventually have negative effects on consumers and corporate earnings. And as we wrote recently, share prices must, ultimately, be underpinned by earnings growth, which will likely slow as a result. At the very least, we think stocks should be pricing in higher uncertainties and risks — including the effects of quantitative tightening (QT) as well as geopolitics and war, which are highly unpredictable — with lower valuations.
Is the worst over for stocks?
Markets appear to believe so. Both the stock and bond markets have rebounded smartly in November, on the back of growing consensus that interest rates have peaked. The rally at the start of the month — the best weekly gain for stocks so far this year — partially recouped losses from the August to October sell-off, which was triggered by the steep rise in longer-dated yields (see Chart 1). The CBOE Volatility index, the market’s “fear” gauge, has also fallen sharply in recent days (see Chart 2).
Yields on the 10-year Treasury have fallen back some since hitting 5% (16-year high) in October, on the back of data suggesting the economy is (finally) showing signs of cooling. For example, the US service sector expanded at the weakest pace in five months, October job growth moderated to 150,000 (from 297,000 in September) and the unemployment rate rose to 3.9%. The Atlanta Fed’s GDPNow model — which is a running estimate based on economic data as and when it is released — estimates 4Q2023 gross domestic product (GDP) growth slowing to 1.2%, from the 4.9% annualised clip in 3Q2023.
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In effect, “bad news” for the economy was taken as “good news” for stocks, as reasons for the Fed to end its current rate hike cycle. But if interest rates have peaked and the Fed starts cutting because the economy is slowing rapidly, that is bad news for corporate earnings — and stock prices. If not, a renewed rise in interest rates is also bad for stocks. Lose-lose.
Earnings estimate for 4Q2023 pared back sharply
Corporate profits surged in 2021 and stayed high. The net margin for the S&P 500 companies stood at 12.1% in 3Q2023, higher than the five-year (pre-Covid-19 pandemic) average of about 10.6%. In addition to efficiency gains and fiscal boost (more on this later), we attribute the margin gains to “greedflation”. Many businesses have taken advantage of robust consumer demand (thanks to free money from the government) and supply disruptions since the pandemic to raise prices beyond their cost increases (that likely also contributed to the high inflation).
According to FactSet, the earnings estimate for 4Q2023 was revised sharply lower during the month of October, from 8.1% year-on-year (y-o-y) growth to 3.9% — the steepest cut compared to the last five-,10-, 15- and 20-year averages, which ranged between 1.7% and 2%. For the whole of 2023, earnings for the S&P 500 companies are estimated to increase by 0.6%. The cut in earnings forecast came despite the fact that 3Q2023 earnings are running well above expectations (in terms of number of positive surprises as well as magnitude of the beat).
Right now, earnings are still expected to grow a robust 11.9% in 2024 on the back of a 5.5% increase in revenue. Based on these estimates, stocks are trading at a price-to-earnings (PE) of nearly 18 times, slightly above the 10-year average of 17.5 times. Clearly, the stock market is still priced to perfection.
We suspect over the coming months these forecasts too will be revised lower. According to the International Monetary Fund (IMF), US GDP growth is expected to slow to 1.5% in 2024, from 2.1% this year. As the economy slows, we believe companies will gradually give up some of their record-high margins in order to remain competitive and sustain sales. When this happens, earnings will fall or, at the very least, earnings growth will slow. And when earnings are revised down, so too will share prices. Remember, share prices are driven by underlying earnings (Chart 3).
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Cost of borrowings not all about the Fed
The Fed sets the short-term interest rate, but longer-dated Treasury yields — which form the benchmark cost for almost all other forms of borrowings — are also driven by market forces of demand and supply, pricing in various factors including inflation expectations and the so-called “term premium”. The latter reflects the compensation for risks in holding Treasuries beyond the very short term.
One big reason behind the secular decline in Treasury yields since the 1980s was lower inflation and expectations, which were in turn driven by falling prices of goods due to globalisation and cost optimisation of supply chains. China, in particular, provided a huge supply of cheap labour to the world, driving manufacturing costs lower while at the same time diminishing labour bargaining power everywhere else, and especially in developed economies including the US.
Today, the world is in the process of deglobalisation, no thanks to lessons from pandemic disruptions and more so, geopolitics. The Western world is intent on “de-risking” from China, reducing investments in the country and shifting supply chains. Globally, trade barriers are rising along with populism-driven protectionist policies. The US-China tech war is worsening, not just in terms of broadening export restrictions but also threatening global collaboration in open-source technologies that could ultimately slow innovation. Current US policies are focused on the reshoring of critical manufacturing such as the semiconductor chip and electric vehicle industries, where operating costs are higher. In addition, recent events indicate workers in the US are regaining bargaining power — if the big wins for striking United Auto Workers and Hollywood writers and actors are any guide — and underpinning stronger wages growth.
In short, there will be more fragmented global supply chains and higher built-in redundancies. Add this to periodic (and likely, increasing) climate-related supply disruptions and the cost to tackle climate change as well as geopolitical tensions in various parts of the world and, inevitably, costs will rise, reversing the falling price trend that drove inflation — and interest rates — lower in the past decades.
Furthermore, the Fed is in the process of reversing more than a decade of quantitative easing (QE), when it bought massive amounts of long-term Treasuries and mortgage-backed securities (MBS) — regardless of price — and flooded the financial system with liquidity (its purchases were paid for through the creation of bank reserves). The increase in reserves encouraged bank lending — abundant and cheap money supercharged consumption and investments and (less desirably) fanned speculation in risky assets, creating bubbles.
QE drove yields lower across maturities — by reducing the supply of Treasuries and lifting prices higher (price and yields are inversely correlated). Yields on the 10-year benchmark Treasury fell to a historic low of 0.5% at the height of the pandemic in 2020 — with the Fed funds rate near zero and term premium deep in negative territory (as low as -1.67%) (see Chart 4). The Fed ended QE in March 2022 and started QT in June 2022 to shrink its balance sheet by allowing preset amounts of maturing Treasuries and MBS to “roll off” (not reinvested).
In the absence of the Fed as a ready buyer at a time when the US is issuing more debt to finance its fiscal deficit, investors are now demanding higher term premium for Treasuries. Indeed, the market has attributed the sharp rise in longer-term Treasury yields in the last three months to the rising term premium, which is now back in positive territory but still far below pre-GFC levels.
Foreign demand for Treasuries — including from biggest holders, China and Japan — may not keep pace with rising supply, due in part to weaponisation of the US dollar and geopolitics. With falling Western investments and trade surplus, China will have less foreign reserves to reinvest (the peak in its official foreign reserves coincided with peak holdings in US Treasuries, in 2014). And Japanese investors are expected to repatriate funds home with the gradual normalisation of monetary policies by the Bank of Japan (made necessary by the falling yen, which is causing populist backlash from the higher cost of living).
In short, if you add up higher inflation (and short-term rates) expectations and term premium (also taking into account heightened uncertainties including geopolitics), there is every reason to expect yields to remain at levels far higher than they have been in the past decade and a half. The yield curve should re-steepen to approximate its more traditional upward slope. In the 10 years prior to the GFC, yields for the 10-year Treasury averaged around 4.9%.
Higher-for-longer interest rates will hurt households and businesses
We believe the economy and markets have yet to fully feel the impact of the Fed’s aggressive rate hikes, or the effects of QT.
We have explained some of the reasons why in previous articles, including fixed-rate mortgages and corporate bonds issued at very low interest rates (especially during the pandemic years) as well as huge government handouts that buffered consumers and businesses from the immediate impact of higher borrowing costs. The labour market, too, has been robust and wages are rising, giving consumers confidence to spend. But this will not last forever. The savings buffer from the pandemic will deplete and loans must be refinanced.
Higher-for-longer interest rates — the price of money — must eventually hurt consumption and investments, and as a result, slow the economy. For one, higher borrowing costs will raise the hurdle for investments, culling the number of projects that would be undertaken if money is very cheap. In other words, fewer projects are financially viable.
Of course, the impact will differ depending on the company’s balance sheet. Cash-rich companies like Berkshire Hathaway are benefiting from higher interest income. But many leveraged companies will suffer. Debt servicing costs will rise when businesses must refinance existing borrowings (which were taken at much lower interest rates, especially in 2020-2021). According to the IMF, some US$5.5 trillion of corporate debt will come due next year, globally. Chart 5 shows the amounts of US corporate-grade and high-yield bonds that need to be repaid and/or refinanced over the next few years, and current yields (the cost if they were refinanced today).
Higher interest expense means lower margins and profits — and lesser amounts available for capital expenditure (investments) and new jobs. Companies with non-viable business plans that nonetheless thrived on cheap money must cut back sharply or go bankrupt. WeWork, the co-working office space start-up once valued at US$47 billion, filed for bankruptcy earlier this month.
US corporate profits since the GFC were increasingly driven by government deficit spending (the Levy-Kalecki profit equation). This is especially so since the pandemic — which saw a big jump in corporate profits — on the back of massive fiscal stimulus packages that injected cash into the circular flow in the economy (and into the business sector) (see Chart 6).
In the world of low and falling interest rates, larger fiscal deficits and mounting debts are still somewhat palatable. Case in point: Although total public debt to GDP has doubled since the GFC, debt servicing costs (as a percentage of GDP) have remained flattish, at least until the Fed started its current interest rate hike cycle in 2022 (see Chart 7). But with rising interest rates, high debt levels become a drag on economic growth, as more of the budget is spent on interest expense, leaving less for other expenditure and development.
The one bright spot is US households. As we said, the labour market is still robust and wages are rising. Many existing homeowners are sitting on substantial home equity, even though home ownership affordability is getting worse for first-time buyers. Strong stock market gains over the past decade have further boosted household wealth.
US consumers have continued to spend despite surging prices and rising interest rates, so far. However, as pandemic excess savings are depleted and credit card debt rises, there are signs that consumers — particularly lower-income households — are cutting back, starting with discretionary spending. Credit card is very costly debt, at more than 20% average annual percentage rate.
Last but not least, we think that markets are underpricing the negative effects — and risks — from QT. QT is contractionary monetary policy, the reversal of QE, which is expansionary. Yes, the size of QT is much smaller than QE; that is, the shrinking of the Fed’s balance sheet is a lot more gradual than its expansion under QE. In fact, its impact is likely not immediately felt, given the huge excess liquidity. However, the effects on the economy will snowball with time, as more and more liquidity is drained from the banking system.
Chart 8 shows slowing y-o-y growth for M2, the broad measure for money supply in the economy, which has fallen into the negatives since December 2022.
QT works opposite to QE — it reduces money supply and shrinking reserves in the banking system mean tighter lending conditions. Lesser credit will inevitably result in lower investments and consumer spending — and accordingly, weaker demand (sales) and corporate profits. Case in point: Recent surveys indicate that banks have already tightened lending standards and loan demand is weakening.
Conclusion
We have attempted to analyse the impact of major current events on the economy and stock market. Obviously, the issues are complicated (many moving parts) and, as such, their implications-effects continue to generate heated debate. But here are our conclusions:
(1) The Fed will hold fast to its 2% inflation target (barring any catastrophic event);
(2) There is a strong case for interest rates to stay higher for longer, despite prevailing market expectations for a quick Fed pivot next year;
(3) Even when the Fed starts cutting, longer-term interest rates are unlikely to return to levels seen post-GFC anytime soon;
(4) QT will continue to drain liquidity and tighten financial conditions, even after interest rates have peaked; and
(5) Tighter financial conditions will negatively impact corporate margins and profits — through weaker consumption and demand, investments and government spending.
We think uncertainties over the health of the US economy and corporate earnings will continue to rise over the coming months. The impact of QT on the economy and financial markets is poorly understood (and rarely talked about), with very limited historical precedence. Volatility in the stock market will return. Current corporate earnings forecasts remain too optimistic. With margins at historically high levels, companies are likely to give up some profitability to maintain competitiveness in a weakening economy. Plus, prevailing valuations are too high with too much hope (and hype) riding on generative artificial intelligence-related productivity gains to offset all of the abovementioned headwinds.
A lot of the stock market gains since the GFC were driven by valuation expansion, on the back of falling interest rates. If this secular trend is indeed reversed, then future stock gains may well be far more modest than investors are accustomed to and currently expect. We suspect over the coming months, bonds will regain attractiveness — as the economy slows and with real yields on the benchmark 10-year Treasury now well above 2%, the highest since the GFC. But for the moment, cash still offers the best risk-reward proposition.
And yes, we fully appreciate the fact that the “tide goes with the bull”. That is, over the longer term, economies grow, the stock market goes up, inflation is almost always positive and therefore, one should stay invested in equities. So, this near-term opinion of ours is contrary to rational conventional thinking. But we do feel there are times when we should leave “convention” outside the door.
“There is time to go long, time to go short and time to go fishing.” — Jesse Lauriston Livermore
The Malaysian Portfolio gained 0.5% last week, on the back of improving investor sentiment globally. Shares for Insas were up 2.3% for the week. Total portfolio returns now stand at 159.1% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 19.8%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
