The long-awaited US recession is now looking less and less likely to happen, at least according to the markets. We have no doubt a recession will eventually come to pass — it is part and parcel of economic and business cycles — but not imminently so, despite the most aggressive Federal Reserve interest rate hike in decades. This has confounded many bearish forecasts at the start of this year — and US stocks have rallied, contrary to expectations. Where the US markets go from here is of great significance, and not just for investors in US stocks, because positive or negative sentiment will spill over into other markets globally.
US households and businesses are less sensitive to interest rate hikes this time
Traditionally, interest rate hikes work to slow down the economy by raising the cost of borrowing. For instance, households would spend less as loans — such as mortgage for homes and hire purchase for cars — become more expensive and interest charges for credit card balances rise. Lower consumer demand and higher interest rates would result in businesses scaling back or delaying investments, further dampening economic activities. Given that household consumption accounts for more than two-thirds of gross domestic product (GDP), any slowdown will have significant impact on the economy.
This time, however, the steep rise in interest rates has been far less effective in slowing down the economy. A major reason for this resilience, thus far, is due to the fact that many households and businesses have taken out long-term fixed rate borrowings at very low interest rates — in the years of falling and near-zero interest rates during the pandemic.
Case in point, 60% of outstanding home mortgages were taken out within the last four years and almost 80% are based on fixed rates with more than 15-years’ tenure. According to a report by Black Knight, a mortgage technology and data provider, more than 73% of outstanding home mortgages as at end-June 2023 had rates below 4.375%. That is well below the yields on cash today.
Similarly, a recent Bank of America report indicates that only 14% of debts for S&P 500 companies are based on floating rates, where they are immediately repriced higher. A whopping 76% of the debts consist of long-term fixed rate borrowings while the remaining 10% are short-term fixed rate debts. This means that the impact from rising interest rates are spread out over years, giving companies time to adjust.
At the same time, the sharp increase in short-term interest rates is boosting income for households with savings and corporates with big cash piles. As we wrote last month, cash is no longer trash. Money market funds and high-yield savings accounts are offering yields above 5%. That means cash-rich companies are now making good returns on their cash, from practically zero yields just 1½ years ago. Case in point, Warren Buffett revealed that he has been buying US$10 billion worth of 3-month or 6-month T-bills every Monday. Berkshire has a massive US$147 billion cash pile, of which some US$97 billion is invested in short-term Treasury bills.
Following years of deleveraging after the global financial crisis (GFC) and generous government pandemic handouts, US household debt-to-GDP is at the lowest in two decades, of which a significant portion is in low fixedrate mortgages. While credit card debts have risen from pandemic lows to above US$1 trillion, they remain at the lowest levels in terms of percentage to GDP since the GFC. This solid financial footing has allowed consumers to keep spending even as prices rise.
Robust consumption, in turn, underpinned hirings, keeping unemployment near record lows and raising wages faster, especially for lower-income households — creating a positive feedback loop for consumption. Huge gains from the stock market in the past few years too have had a positive wealth effect for the rich and savers are benefiting from much higher interest income. All of these factors are working in confluence to keep the much-anticipated recession at bay.
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In fact, the US economy is doing far better than expected. GDP growth improved from 2% in 1Q2023 to 2.4% in 2Q2023 and based on the Atlanta Fed’s GDPNow model — which is a real-time mathematical model based on available economic data — 3Q2023 economic growth is currently running at 4.1%.
So are corporate earnings. According to FactSet, more than four out of every five S&P 500 companies that have reported earnings for 2Q2023 beat analysts’ forecasts. Earnings are now estimated to decline by 5.2% for the quarter, better than the 7% drop forecast at end-June 2023. Margins too have held up well, currently estimated at 11.5%, which is about the 5-year average of 11.4%. Earnings for 2023 is forecast to grow by 0.8%.
In short, the resilient economy is holding up corporate earnings and profitability. And this is why US stocks have outperformed expectations, which has many analysts and economists scrambling to pare back their bearish bets in recent weeks.
Cash has the best risk-reward proposition at this point
Our issue with US stocks is that valuations remain too high, even if earnings are holding up. Both trailing and forward PER for the S&P 500 are currently above the averages for the last 20 years (see Table).
Put another way, earnings yield (which is the inverse of PER) for stocks has plunged after this year’s rally to 4.6% currently. Earnings yield fell — valuations expanded with earnings staying flat — while Treasury yields rose. As a result, the equity risk premium — the excess returns for equity over risk-free 10-year Treasury — has fallen to just 0.37%, the lowest since June 2004 (see Chart). To sustain the rally, Treasury yields have to fall and/or earnings will have to grow much more rapidly, faster than growth rates in the last 20 years. Could they?
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Yes, consumer spending has been much stronger than expected. But that also means that inflation would be stickier. Indeed, the pace of decline in inflation has noticeably slowed in recent months — and could even tick higher again.
We have previously written about the reasons why the secular decline in inflation of the past few decades has reversed, taking into account the costs of deglobalisation, energy transition, US-China tech ecosystem fragmentation and so on. In short, we think inflation is unlikely to fall back to the Fed’s 2% target anytime soon. Therefore, it is quite likely that interest rates too will have to remain higher for longer.
Current long-term interest rates have yet to fully reflect this sticky inflation scenario. In other words, prevailing expectations for future interest rates are still too low. Hence, we believe that yields on long-dated Treasuries will move upwards from the current “low” levels. This poses risks to bonds of longer maturities. Remember, yields and bond prices move in opposite directions.
Additionally, there are some concerns that investor appetite for Treasuries may be showing signs of weakening, which would push yields higher. This worry could grow if and when the Bank of Japan ends yield curve control and allows yields to move higher, luring Japanese pension and insurance funds currently invested abroad back home.
Billionaire investor Bill Ackman recently revealed that he is betting against 30-year US Treasury as a hedge against the impact of long-term rates on stocks in “a world with persistent 3% inflation”. We agree with this view.
It is possible that investors believe stocks are a better bet than long-dated bonds at this point. Bonds, with fixed-income streams, will fare worse in a higher inflationary environment. Even though valuations for stocks will also be negatively affected by higher interest rates, higher input costs (at least partially) can be passed through to consumers — as long as the economy remains relatively healthy. And as we explained above, it no longer appears that recession is imminent, though one may still come over the next one year. Corporate earnings and margins have held up fairly well amid rising costs thus far, underscoring pricing power.
We have no doubt that at some point, the cumulative interest rate hikes and higher-forlonger borrowing costs as well as higher prices must have some dampening effect on consumption. Pandemic savings are dwindling. Student loans repayments are set to restart in October. The global economy is slowing and the outlook is uncertain for China, the world’s second largest economy. The question is to what extent?
There is also a lot of hope — and hype — that generative artificial intelligence (AI) will propel productivity gains and corporate earnings growth sharply higher for the foreseeable future. This could offset slower consumption and thereby justify the higher stock valuations. Generative AI will replace some human jobs and it will make many others easier, more productive and efficient. (We will write more on this subject in the near future.) We believe the generative AI-driven productivity gains are real, though we do not yet know the breadth of its transformative impact or how fast and how successfully companies can monetise its usage. There is a real risk that reality will disappoint.
In conclusion, stocks may weather persistent inflation better than bonds, but they do come with much higher risks, and especially so for richly valued companies riding the AI wave. The best risk-reward proposition right now is cash and short-term Treasuries. As mentioned above, Treasury bills, money market funds and high-yield savings accounts are offering yields above 5% — that is, positive net yield after inflation — for minimal to no risk. That has not happened in the past 16 years.
The Malaysian Portfolio fell 0.5% last week, weighed down by losses from Hartalega Holdings (-2.4%) and Star Media Group (-3.7%) that more than offset gains from Insas (+3.0%) and KUB (+1.9%). Total portfolio returns now stand at 155.4% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 20.0%, 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.
