After a stellar start to the year in the S&P 500, it fell in October for the 3rd straight month by 2.2%. The tech heavy NASDAQ traded down almost 3% and the biggest weakness was seen in the smaller stocks as measured by the Russell 2000 which declined by 6.9%. Smaller companies are certainly more impacted by the sharp rise in interest rates and don’t have the same privileges as the bigger companies do in terms of having a multitude of funding options. The selloff was global as the Euro STOXX 600 index traded lower by 3.7% and Asian markets did as well. The Nikkei was down 3.1% and the Shanghai composite was weaker by 3%.
As seen in the prior two months that drove a decline in stocks, we can blame a continued rise in long-term interest rates as global bond markets sold off again. The US 10yr yield was up 36 basis points in October to 4.93%, though it has fallen back to 4.58% as of this writing. The Japanese 10yr JGB yield, which I believe the genesis of the recent selling of global sovereign bonds, was higher 18 basis points to .95% and that monthly close was more than double the .42% at which it ended 2022. It, too, has since fallen back to .88%. Although it should be noted that European bond yields, after the recent jump in months prior, were little changed for the month of October.
As I wrote about in September’s monthly letter, 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-year JGB yield to move up to as much as 1.00% as a reference rate implying, they will tolerate a rate higher than that. In late July they shifted this now soft cap from .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% long term 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 of 6.2% for the full fiscal year 2023 ended September, that means the US Treasury needs to issue a lot of debt to raise the money to finance the widening deficit. This large amount of supply is happening while some very large 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 in the few years up until 2022 as they were flooded with deposits. And lastly, foreign holders of US Treasuries have reduced their ownership stake to near 30% from the mid 40% level about ten years ago. On the flip side, US retail and institutional buyers are finding the current yields very attractive, but part of the buying on the institutional side is via hedge funds who are just putting on a trade versus the Treasury futures market in something called a ‘basis trade’ rather than purchasing US Treasuries.
As seen in November, we have gotten some relief from the sharp rise in long-term interest rates as they’ve pulled back for a few reasons. One, the most recent BoJ meeting, which saw them give more flexibility in yield curve control, did not change the negative rate policy they still employ. Also, we saw a rally in European bonds after a softer than expected inflation report and a softer than expected US payroll number with the unemployment rate rising to the highest level since January 2022. With a respite that could last in the short term, I still anticipate that long term interest rates to surprise to the upside in 2024.
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, households, 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 the rapid rise in interest rates in a very condensed time frame came after 15 years of artificially suppressed interest rates.
The notable thing here is that longer term rates are rising even as inflation and oil prices are moderating. It’s also happening as economic activity around the world seems to be muted, particularly in Europe and China. The US economy saw in November an amazing 4.9% GDP print for Q3 but with uneven contributors. Personal spending was the main driver, particularly consumer spending on leisure, hospitality, and travel. There was also a big lift to inventories and for government spending. Business spending was little changed. We should expect a slowdown in the pace of activity in Q4 and I believe even more so in 2024.
With respect to the Federal Reserve, they sat on their hands at the November 1st meeting as they did in September which followed the 25 basis point rate increase back in July. I believe they rightly stood pat as the big rise in long term interest rates was a de facto further tightening as the average 30-year mortgage rate rose about 100 basis points since that July Fed rate hike according to Bankrate. But while the Fed is now sitting tight and most likely done with short term rate increases, they are still reducing the size of their balance sheet, via QT and that itself is a continued form of monetary tightening as is keeping rates around current levels for a prolonged time period.
It's hard not to talk about market and economic activity in October without touching on the new geopolitical worry, that being the Middle East that began with the horrific attack on Israel. Historically speaking, geopolitical events, outside of world wars, mostly have a fleeting impact on economic activity and markets globally as there is not enough disruption to move the needle however awful the events might be. Oil prices, for example, as of this writing are little changed from where they were before the October 7th attack. That said, we are certainly watching closely, especially if Iran gets more involved and the situation gets worse.
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.
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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