August 22, 2023
Good morning,
Recall that I changed the cadence of the Morning Notes to only twice per week during August because I anticipated a quiet month. Wrong! It’s been anything but quiet, particularly in the bond market. But change is often healthy, so I’ll stay two/per for the next 3 wks accounting for the Labor Day holiday week. Embracing change this morning, let’s go macroeconomic and fundamental instead of the usual heavy dose of technical.
Economic strength in the face of significantly higher rates has been the biggest surprise to investors so far this year. While 7-8 mega cap names have had an outsized “AI” effect on the +20% S&P 500 Index peak gain (12/31 – 8/1) this year, other indexes with much less AI exposure were still up mid-teens for the same period. There are several macro/fundamental reasons why it should be very hard for the market to keep that upward trajectory for the rest of the year. That doesn’t mean the equity market has to collapse, but if we take away the path upward, sideways, or downward are the only paths left.
As mentioned, one of the defining characteristics of the current bull market is the return to dominance of mega-cap tech names. One of the consequences is that they have amplified the jump in price/earnings multiples. During the early stages of bull markets, “P” often rises faster than “E,” so multiples expand. On average P/E multiples rise 3.9 points during the first 11 months of a bull market. Multiples have jumped 7.0 points for this bull (AI effect). Growth is supposed to kick-in now and normalize the ratio as “E” catches up. However, with the Fed maintaining its tightening bias, it would seem less likely for growth to expand and more likely for “P” to normalize the ratio back to historical fair value.
Let’s go macro now and look at budget deficits from a two-handed economist’s viewpoint. On the one hand, the huge jump in the budget deficit this year has aided economic growth, profits, and stock prices. On the other hand, debt service has exploded. When government debt as a percentage of GDP is as high as it is now, economic growth has been about half what it was when debt was relatively low. This debt/growth relationship may be important in the weeks ahead as Congress must pass spending bills. There is no debt ceiling, but still, there is a fair chance this will cause another fight in the House of Representatives to shut down the government.
Staying Macro – Bond yields have come a long way in a short period of time. Ten-year Treasury yields have backed up 100 bp from their April lows. Growth expectations (soft landing) and an increase in the supply of Treasuries (issuance) have contributed to the rise in yields. But I suspect there’s another factor as well. Inflation expectations are un-anchoring from the Fed’s stated 2% target. Term premiums are rising and could push 10-yr Treasury yields back toward 5.25% where they were in 2006-07. Inflation has come down since the spring, but further progress over the balance of the year may prove more difficult. Led by energy, commodity prices have bounced. House prices have rebounded, and rents have stabilized, which could cause shelter costs to remain sticky. Medical care inflation is likely to accelerate in Q4 on revised pricing, contributing to core inflation.
And then there is Fed watching – In Chair Powell’s Jackson Hole address on Friday, it is probably premature for the Fed to embrace a higher inflation rate and, therefore, a higher inflation target. The market has been consistently underpricing the risk of additional rate hikes and overpricing the speed of rate cuts. It would seem like the Fed will keep with a tightening bias.
Be well,
Mike