Market Commentary - September

Monthly Update

As we review September, the continued rise in long term interest rates has been the main headline story and it’s not just happening in the US, it is a global phenomenon. Just when we thought that short term interest rates were nearing their peak as inflation moderated and the Fed and other central banks were nearing the end of their aggressive rate hiking steps, longer term interest rates spurted higher. The US 10 yr. yield jumped 46 basis points in September to close the month at 4.57%, but as of this writing its touching 4.78%[1]. These are levels last seen in 2007 and the yield started the year at 3.88%[2]. For many readers, these rates may still appear historically low; however, it's crucial to note that they are being compared to the 15-year period leading up to 2022 when the Fed began raising rates, which had an average of 2.52%[3].

After jumping by 25 basis points in July and August, which is a notable move here, the Japanese 10 yr. yield was up by another 11 basis points in September to close at .77%, the highest since 2013[4]. The German 10 yr. bund yield as of this writing is at a 12 yr. high at 2.94%. That compares with 2.47% at the end of August[5]. Yields rose too in the UK, Australia, Canada to name some others experiencing the same thing.

There are a few factors at work here that are combining for the upside moves. I think a major influence has been the move by the Bank of Japan to allow its 10 yr. JGB yield to move up to as much as 1.00% after trying to suppress it below .50%. I bring this factor up because the Bank of Japan is the last major central bank to tighten monetary policy in response to higher inflation. Consumer prices excluding food and fuel in Japan is running around twice the level of their 2% inflation target. Another rate factor has been the growing realization that central banks plan on keeping short-term interest rates higher for a while to keep inflation from flaring up again. Also, quantitative tightening is happening not just in the US but elsewhere where the Fed, ECB, BoE and BoC are essentially selling government bonds.

The last reason, which I believe is pretty important, is due to the ever-rising US debts and deficits. With a US budget deficit near 8% for the 12 months ended July, that means the US Treasury needs to sell a lot of treasuries in order to raise the money to finance the widening gap. This large amount of supply is happening while some very important players are no longer buying. The Fed, as stated, is letting its bond portfolio shrink and no longer adding treasuries to their balance sheet. Banks are reducing their holdings after being a large buyer up until 2022. And lastly, foreign holders of US Treasuries have shrunk their ownership stake to near 30% from the mid 40% level about ten years ago[6]. On the flip side, US retail and institutional buyers are finding the current yields very attractive but that doesn’t yet seem to be enough and that the yield clearing price continues to be move higher.

In the latest downdraft in the stock market, the small cap Russell 2000 has given back its gains for the year and is now down. As of this writing the S&P 500 is still maintaining a 10% year to date gain thanks to strength in the biggest technology stocks and even after a 7-8% fall off the highs of 2023[7]. Those big tech companies have the NASDAQ still up about 25% year to date, a nice bounce after the weakness seen in 2022[8]. International stocks have also come off their highs of the year too, though mostly still up year to date, as no one right now is immune from the rise in interest rates.

The challenge for stocks is that the rise in interest rates negatively impacts the US economy at the same time it reduces the multiples investors are willing to pay for equities. Also, the rise in rates creates refinancing risks for companies and investors, particularly in real estate, that have loans coming due because the rates on offer are most likely much higher than the rates on the loans maturing. This is because of the rapid rise in rates we’ve seen in a rather condensed time frame over the past few years.

The key thing here is that longer term rates are rising even as inflation is moderating, notwithstanding the recent jump in energy prices. It’s also happening as economic activity around the world seems to be muted. The August consumer price index in the US saw the core rate fall to 4.3% from 4.7%, which is the 10^th month in the past 11 with m/o/m declines[9]. The core rate of inflation for September in the Eurozone fell to 4.5% from 5.3% in August. In the UK, the core CPI softened to 6.2% from 6.9%[10]. This all said in listing these stats, the recent rise in oil prices is complicating the inflation picture if the price gains are maintained because it can filter into a lot of other parts of the economy.

With respect to economic growth, data seen so far is pointing to a Q3 contraction for Germany and possibly for the UK. China’s economy is struggling with its property sector and a global slowdown in manufacturing. The US economy is expected to grow in Q3 but with a very mixed situation with services outperforming manufacturing but a large amount of government spending that is boosting construction of new manufacturing facilities.

On this last point, spurred on by US federal government tax incentives, loans and grants, companies around the world are spending billions on factory production in the US to produce for the renewable sector. Also, the CHIPS and Science Act is encouraging the domestic development of a bigger US semiconductor manufacturing presence. Lastly, there is a lot of money now being spent at the state and local level on infrastructure. While the goals are laudable, we’ll have to see about the means in terms of how efficient the spending will be and what capital will inevitably be misallocated to some extent. Either way, this will lift US activity in these sectors but could also help to lift inflation again, in addition to worsening the US fiscal picture, not making the Fed’s job any easier.

The US housing market, most sensitive to interest rates, is upside down as mortgage rates approach 8%[11]. Existing home sales are near the lowest level in about 30 yrs., while new home sales have done much better as builders fill the supply vacuum. The other important interest rate sensitive part of the economy, that being autos, is dealing with a record high price for a vehicle at the same time the cost of borrowing has jumped. Also, with regards to new vehicle supply, we need those UAW strikes to end soon.

As the 2^nd largest economy, a macro review always must mention China and we’ll do so again here without getting into the geopolitical stance that the US and China are both taking. For both plusses and minuses, China has been an important story this year. The good was the reopening of its economy after they rid themselves of the fruitless fight against Covid that they were never going to win via lockdowns. The challenges include the sharp downturn in their residential property market and the global manufacturing slowdown coincident with the reduction in global trade. The bright spot of the Chinese economy has been consumer spending on travel, leisure and hospitality as people get back to some normality post Covid. As I write this, China is in the middle of their Golden Week Holiday and early reports are positive for spending in this sector.

Conclusion

After a lengthy period of about 15 years of extraordinarily low and artificially suppressed interest rates, the new higher interest rate environment continues to evolve, and the transition is certainly bumpy and will likely remain so for a period of time. The adjustment and withdrawal period from that low-rate world will impact both economic activity as the cost of capital is much higher and the prices of assets as they absorb a higher discount rate. When stretching out the view over the past few years, the stock market is in a wide trading range and the risk-free rate above 5% is quite attractive in this context, creating a higher return hurdle rate.

There are many puts and takes on things and balancing everything is what we are trying to do. We acknowledge that we live in a different macro environment and need to have eyes wide open on how things proceed from here. Whatever comes our way though in this very tricky investing landscape, it remains vital that investors have adequate short-term liquidity over the next 2-3 years. Knowing that period is covered can help separate the balance of one’s portfolio from the ups and downs of the market. Time horizon is very crucial right now and is always the best friend of any investor.

Disclaimer

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[1] Bloomberg

[2] Bloomberg

[3] Bloomberg

[4] Bloomberg

[5] Bloomberg

[6] Bloomberg

[7] Bloomberg

[8] Bloomberg

[9] Bloomberg

[10] Bloomberg

[11] Bloomberg