Higher for Longer

October 12, 2023

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The September effect was in full force again this year as the global sell-off continued. Nearly all major financial assets lost ground last month.

“Higher for Longer” was the quote Jay Powell used to trigger a steep rise in long dated US Treasury yields, which unsettled the stock market, and caused major losses in the bond market.

Global government bonds posted the biggest losses. In equity markets, the U.S. market underperformed as the U.S. has more exposure to growth stocks, which are more affected by the higher treasury yields.

The price of oil surged by 9.8% in September, and fueled concerns that central banks will have to maintain a tight monetary policy stance for longer. Meanwhile, global risk-off sentiment boosted the performance of the counter-cyclical US dollar, which also benefited from the relative resilience of the U.S. economy.

In the September FOMC meeting, the Fed held the funds rate steady and made no material changes to its policy statement. That said, the FOMC did make significant changes to their economic and interest rate projections.

First, the median forecast for real GDP growth was revised significantly higher for 2023 and 2024. Consistent with its stronger growth outlook, the Fed also reduced its median unemployment rate forecast from 4.1% to 3.8% for this year and from 4.5% to 4.1% for next year. On inflation, the Fed’s median 2023 forecast for core PCE was revised down to 3.7% from 3.9% while the 2024 forecast was left unchanged.

Finally, and most importantly, the Fed’s median interest rate forecast was unchanged for 2023 and was revised up significantly for 2024.

The FOMC continues to anticipate that one more 25 basis point rate hike will be necessary before the end of this year, and now anticipates far fewer 2024 rate cuts than was the case in June. In other words, the Fed expects interest rates to stay “higher for longer”.

It’s All About Jobs and Wages

The recent US Nonfarm Payroll data report delivered a strong positive surprise about employment growth in September. Job gains accelerated from 187 thousand to 336 thousand, significantly above expectations.

Importantly, the gains were broad-based across industries with all sectors experiencing job gains last month.  Such positive numbers seem to confirm the risk of higher for longer on the surface, but unemployment levels and wages tell a different story.

Despite the strength in the jobs market, there are no signs that wages are rising faster than inflation. Average hourly earnings increased only 0.2% in September, below consensus expectations. This is a positive for companies as they will be able to maintain profit margins.

One potential reason for wages not rising is that these 336 thousand new jobs are driven by people taking on a 2nd job to pay the bills, rather than an unemployed person becoming employed for the first time. 2 jobs is good, but needing a 2nd job because the 1st doesn’t pay enough is not.

In fact, alongside the employment survey that counts jobs, the government calculates a household survey that counts people employed, counting everyone once. That number was much softer, with only 86 thousand new people employed, in line with population and labor force growth. As a result, the unemployment rate didn’t change even though the number of jobs grew.

In short, the strong jobs number is at least partially due to people taking on extra work, rather than newly employed people who will tighten the labor market and drive up wages,

A Soft-Landing

Given the disinflation in goods and a falling inflation in the services sector, it is likely that headline inflation will continue to fall in the coming months. The weakness in the Chinese economy is currently helping the U.S. inflation outlook.

So, could we see a strong U.S. economy with lower inflation, or in other words a soft-landing? Perhaps. The problem is that the economy is always dynamic and will not stay in the same state for long.

Therefore, a soft-landing scenario is sort of a myth. Even if the economy temporarily achieves such a state, it won’t last.

Eventually, we will likely see a recession as higher interest rates do have a slowing effect on economic growth. The big question is when this will happen.

It is possible that we could see an economic slowdown in 2024. However, it is also possible that a rebound in the manufacturing cycle and additional capital expenditure could support economic growth next year, meaning a potential recession is even further into the future.

Equity Markets

Stock markets tend to correct about 6 months before a recession starts. As we do not expect a recession in the very near term, there is still upside potential for markets in the months ahead.

Profit margins have returned to their 2019 levels after surging during the pandemic. While margins could fall during the next recession, with sales and nominal GDP still growing at a reasonably healthy rate, earnings estimates should continue to rise for the next few quarters.

Another factor that could potentially aid stocks is that sentiment and positioning are not yet stretched. Fear of missing out in June/July have turned to overall bearish sentiment once again after two medicore months for equity markets in August and September. According to the latest BofA Global Fund Manager Survey, institutional investors were around one standard deviation underweight stocks in early September. Moreover, speculators remain net short S&P 500 futures.

International stocks could outperform into year-end. European and Japanese stocks have seen faster growth in forward earnings and sales estimates since the start of 2022 than their U.S. peers. They are also quite a bit cheaper than U.S. stocks.

China

China is currently experiencing a major liquidity crisis among its property developers, which also erodes confidence in its arguably overvalued property market. At the same time, China’s manufacturers are suffering from lower demand for goods in the west after the Covid period.

Finding alternative source of demand to make up for lower exports and decreased real estate demand sounds challenging, but it should not be. People like to shop. The key is for the Chinese government to run an expansionary fiscal policy, either by spending money directly on public goods or transferring income to households to enable them to spend more.

Granted, such expansionary fiscal policy will mean that government debt increases. However, that is not as much of a constraint as it may appear, at least for governments that issue debt in their own currencies. When an economy suffers from excess savings, interest rates will typically be very low.

The problem is that local governments in China are responsible for much of the spending but have historically relied on land sales for their revenue. These have dried up as housing has slumped. Without an adequate fiscal response from the central government, the Chinese economy remains at risk.

Right now, sluggish Chinese economic growth is not a problem for the U.S. and European economies, which have tight labor markets and are still susceptible to overheating. The fact that Chinese export prices are down 12% from a year ago is arguably a good thing for them. But if inflation risks fade next year while recession risks rise, a weak Chinese economy could exacerbate a global downturn.

Bonds are Looking More Attractive

We have generally had a bearish outlook for government bonds for the past few years. At this point, however, with the 10-year treasury yield at 4.80%, the risk-reward to owning long-duration bonds has improved. An increase in the US 10-year treasury yield to 5.5% would result in a 2% loss. In contrast, a decline in the 10-year yield to 3% – which would be quite plausible in a recession scenario – would result in a 17.8% gain.

Going forward, Treasury yields could trade in a range as the Fed moves to the end of its tightening cycle. A breakout to the upside of that range will only occur if a second wave of inflation spurs a new round of rate hikes, and a breakdown in yields will only occur when pain in the labor market forces the Fed to cut interest rates.

With the running yield of bonds back at 5% and the possibility of capital gains if yields fall, fixed income is definitely more attractive than it has been for many years. Adding more traditional fixed income to diversified portfolios could make a lot of sense for long-term investors.

U.S. Dollar Rally

The US dollar has experienced a roller coaster ride over the last few years. After a powerful rally between mid-2021 and October 2022, the dollar faltered before beginning to strengthen again this July. The dollar’s movements can be explained by mainly two related factors: Interest rate differentials and economic growth dynamics.

In the past two months we saw the dollar strengthening as growth in Europe weakened and China’s once-hoped reopening boom never materialized. Meanwhile, U.S. growth kicked into high gear, sending U.S. rate expectations higher.

From a longer-term perspective, the dollar remains overvalued. It currently trades 21% above its Purchasing Power Parity (PPP) exchange rate. Historically, the dollar’s deviation from PPP has been a good indicator to its long-term direction.

Geopolitics

If trying to understand the macro-economic trends of an economy isn’t already hard enough, there are many unpredictable global events happening that could upend expectations and have a real economic impact.

The official declaration of war by the Israeli government after the Hamas attacks does carry the risk of heightening tensions in the Middle East. This could have an impact on oil prices, which could translate in higher inflation.

Meanwhile in the U.S., we have seen the eviction of the U.S. House speaker McCarthy. The next deadline to fund the U.S. government is November 17. The speaker pro tempore, who is chosen by McCarthy, will fill in until they choose a new speaker.

The new speaker is more likely to be a moderate than a populist, since it will be necessary to retain the support of the 18 moderate Republicans who represent swing districts that Biden won in 2020.

It is possible that a populist could win the speakership, but the odds are lower.

The moderates can only stay in power by cooperating with Democrats. They are closer to Democrats on economic policy than to the right wing of the Republican party. As long as the Democrats do not make unacceptable demands leading to November 17, then the new speaker could compromise with them to avoid a shutdown.

After compromising with Democrats, the next speaker could also fall victim to a motion to vacate. The question at that time will be whether Democrats were able to extract a more lasting government funding deal from the moderate GOP, or whether they were only able to achieve another short-term, stopgap measure.

If Republicans choose a populist speaker, they will force a long government shutdown, and an extended shutdown will have a real negative impact on U.S. economic growth.

Portfolio Actions

Risk sentiment has deteriorated significantly despite, or probably because of, the better-than-expected economic data. The fact that the U.S. economy is doing well, should support corporate earnings. Therefore, we keep portfolios well-balanced between quality and growth exposure.

We recently added long dated US treasuries to the fixed income portfolio. Given the continued rise in bond yields, we are considering increasing this position further. Long-dated government bonds now offer an interesting risk/reward profile in our view. If you’d like to discuss your portfolio exposures with our investment team, please don’t hesitate to reach out.

DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

The Standard & Poor’s 500 (S&P 500) Index is a free-float weighted index that tracks the 500 most widely held stocks on the NYSE or NASDAQ and is representative of the stock market in general.  It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk.

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