After three months of declines, stocks saw a big bounce back in November. The S&P 500 was up 9%, the NASDAQ by 10.7% and the small cap Russell 2000 by 8.8%, thus it was broad based and mostly global. The Euro STOXX 600 index gained 6.5%, the Nikkei was higher by 8.5%, the South Korean Kospi by 11.3% and the Taiwanese TAIEX was up by 9%, to name a few international markets. Stocks in China and Hong Kong were the main laggards as worry about the economic recovery there continues. The main catalyst for these gains was the sharp decline in interest rates across the yield curve after the spike up that started in late July. The reasoning here was the continued moderation in inflation, along with the belief that central banks around the world, maybe except for the Bank of Japan, are done raising interest rates.
After climbing approximately 105 basis points year-to-date through October, the US 10-year yield was down 60-basis points, reaching its peak intraday at 5.00%. As of this writing it is trading at 4.18% vs around 3.75% in July before the rise to that 5.00% level. In the span of the month, the yield on the short-term 2-year Treasury note dropped by 41 basis points. This decline is attributed not only to the market's anticipation of no further rate hikes but also to its current expectation of approximately 125 basis points in rate cuts for the year 2024.
With respect to the moderation in US inflation, in mid-November we saw the consumer price index for October where the headline figure slowed to 3.2% from 3.7%, mostly led by a drop in energy prices. The core rate was 4.0% from 4.1%, only a slight change but the slowest since the fall of 2021 and should slow further as the modest gains in rental growth, after notable gains seen over the past few years, filters into the CPI calculation. In November, Eurozone inflation showed a 2.4% increase in headline figures and a 3.6% rise when excluding food and energy. This represents a deceleration compared to the previous month's readings of 2.9% and 4.2%, respectively. The inflation tick down in terms of rate of change was seen elsewhere too and as a result, in my view, central banks are likely done raising interest rates in the near term.
There are also some growing worries about the global economy that have helped to lower interest rates and provide more reason for hope that central bankers might cut rates next year. With respect to US monetary policy, we know that ‘maximum employment’ is one of the Fed’s mandates. The November payrolls report reflected an unemployment rate of 3.7%, though the October read of 3.9% was the most since January 2022. In that same jobs report, the 6 month average for private sector job growth is now 130k vs the 12 month average of 179k and the 2022 average of 376k. Continuing claims, measuring those receiving unemployment benefits, are at the 2nd highest level since November 2021. In the November consumer confidence index from the Conference Board, the number of those that said jobs are ‘Hard to Get’ rose to the highest level since March 2021. Coincidently, the number of job openings through October fell to the lowest level since March 2021. Lastly, this is what S&P Global said about the US employment situation, the biggest component, in their November services and manufacturing report: “Firms providing both goods and services have become increasingly concerned about excessive staffing levels in the face of weakened demand, resulting in the smallest overall jobs gain recorded by the survey since the early pandemic lockdowns of 2020.” We are closely watching as to how this plays out in the quarters to come.
So, will the Federal Reserve and other central banks comply with what markets are hoping for in 2024? Will we see rate cuts and if so, to what extent. While I do believe we will see rate cuts next year by central banks, I also believe that they will be hesitant to do so to any great degree. Central banks went all in when it came to the easing of monetary policy in response to Covid and were very slow to reverse course, which in my view was the key culprit in the recent 40 yr. high in inflation. Now that inflation is slowing down, that is not the end of the battle. Keeping it down will be, and why I believe there will be a level of stubbornness on the part of central bankers so as not to see a flare up of inflation again where they would then have to reverse themselves.
This is exactly what happened in the late 1960’s and into the 1970’s when we saw a jump in inflation that was followed by a slowdown, then followed by another spike that exceeded the previous move higher. It then dropped again and ended with double digit inflation into the late 1970’s. When inflation jumped the Fed hiked rates and when it fell, they cut. Jay Powell, in particular, doesn’t want to see a replay of this.
There are other factors too that will dictate the direction of longer-term interest rates that are not tethered to what the Fed and other central banks will do with short-term rates. The US has a major debt and deficit problem that must be financed with an ever-growing rise in Treasury issuance. On a dollar basis, the US government has a budget deficit of about $2 trillion on a trailing 12-month basis and as a percent of GDP it stands at around 6%. For an economy that is not in a recession and with an unemployment rate below 4%, these are staggering numbers. So, we will see a further increase in Treasury supply at the same time the Fed will continue shrinking its balance sheet via quantitative tightening where they are essentially selling Treasuries. Also, banks are reducing their holdings of long-term Treasuries and foreigners continue to buy less as a percent of total issuance. I’ll add one more big potential influence on the direction of longer-term interest rates and that is the Bank of Japan possibly ending its negative interest rate policy which could have reverberations in bond markets around the world.
As we look to 2024 both for the economy and markets, it’s important to do a quick look back to where we’ve been. The US economy has handled the most aggressive rate hikes in 40 years over the past two years in a very commendable way, but I question how much longer this can last as more time progresses, more and more businesses and households get caught by the higher interest rate environment we’re in. This while the European economy is at best flat lining and its biggest economy Germany in a slight recession and China, the 2nd largest economy, is facing its own growth challenges.
The positive for the US economy is certainly the drop in rising inflation rates and for consumers that have savings, they can finally earn some good income from it. And while the pace of job hiring has slowed, the rate of firing remains low.
As for markets, the S&P 500 is where it was two years ago but where we had sharp drawdowns and big gains all to go nowhere over this timeframe. With the attraction of 15 year plus highs in interest rates, it is major competition for equities in terms of returns. Can eventual central bank rate cuts save the day in 2024 for both the economy and markets? Hopefully, but I’m skeptical that it will be the saving grace that many believe it will be because both will be in response to slower economic growth, and I believe the easing will be modest in nature.
Fixed income is finally attractive in the sense of providing around 15-year highs in interest rates and one can do so and take limited credit risk via US Treasuries. Equities are bifurcated still between the “cult 7” stocks that have the biggest market capitalizations in the S&P 500 and then everything else where more values are to be had, along with values seen in international markets.
After a lengthy period of about 15 years of extraordinarily low and artificially suppressed interest rates, the new higher 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 the 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, even if seen lower in 2024. I believe that the trading range market we saw over the past two years will continue until proven otherwise. On the rate side, short term rates have most likely peaked as the Fed is done hiking the fed funds rate but I still believe that longer term interest rates will continue to creep higher in coming years, notwithstanding periodic drops like we’re seeing now.
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 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.
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