Three Key Thoughts:
1. Rates Bite Stocks
2. REAL Returns on Bonds
3. Geopolitics: No More World Order

Rates Bite Stocks

For most of 2023, the US stock market has been buoyed by the prospect that the Federal Reserve was almost done raising interest rates because they appeared to be winning the battle with inflation. And the Fed had apparently defied history and won its battle without inducing a recession. What a wonderful result, if it were all true!

For right now, the economy does appear to be avoiding recession, with the labor market still surprisingly strong (even though weaker than earlier in the year) and consumer spending still holding up well. However, the labor market is a notoriously lagging indicator so that could change in a hurry. Our bigger concern is the prospect that inflation could turn higher. The combination of aggressive wage demands in several unionized segments of the economy and higher oil prices portend upward pressure on prices.

Responding to these risks of higher inflation, yields on long-term bonds have jumped dramatically. In the last three months, the yield on the ten-year Treasury bond has risen a full 1%, from around 3.8% to 4.8%. As we saw in 2022, higher interest rates are generally bad for stocks, particularly higher growth companies, as their future earnings value is discounted more. True to form, the US stock market pulled back in the third quarter and, if it weren’t for the gains of a handful of very large technology companies, there would be no gains this year.

Another headwind for stocks: attractive REAL returns on bonds, which makes them more attractive in uncertain times. Taken together, we believe stocks are likely in a holding pattern until there is more clarity around inflation.

REAL Returns on Bonds

At 5.5%, the current target for the Federal Funds rate is well above the reported levels of inflation. Having a “real” (after inflation) return on bonds is a situation we haven’t seen since before the Great Recession of 2008-2009. Until this past quarter, rates on long-term US Treasury bonds had stayed close to the level of inflation, as investors expected inflation to fall.

However, with the labor market reasonably strong and inflation apparently leveling out at a rate well above the Federal Reserve’s target, the Fed signaled at its September meeting that more rate hikes are likely. More importantly, in our view, the Fed’s consensus forecast changed for 2024 to remove interest rate cuts. Investors took this cue to mark down prices on long-term bonds further, driving up yields so that both short-term and long-term bonds now provide a positive real yield.

Not only do higher rates generally mean lower prices on higher growth stocks, these real yields provide a reasonably attractive and much safer alternative to investments in riskier stocks. This type of attractive alternative to stocks hasn’t been available for more than a decade.

Geopolitics: No More World Order

Russia’s invasion of Ukraine shattered a relatively low conflict world that had existed for some time. That war has dragged on with no prospect for end in sight. Despite the obvious importance of stopping Russia’s expansionary aggression, signs of fatigue in Western support are clearly showing.

Meanwhile, China charts a course to a new future as it tries to expand its military and economic independence, the latter made difficult by serious structural problems that have yet to be effectively addressed. From the South China Sea to Taiwan, the Chinese military is making its presence known, combining new assertions of territorial rights with demonstrations of its growing military power.

The Iran-sponsored attack by Hamas on Israel is sure to lead to greater conflict in the Middle East. In the short-term, Israel’s response is likely to be massive. More difficult to predict, however, will be the impact on the regional alliances whose central players are rivals Saudi Arabia and Iran.

These are just three examples of conflicts that have arisen as the US has pulled back on its engagement in the world community. We don’t know where any of these will lead but all pose risks to a peaceful, growing global economy.

Investment Implications

We continue to be cautious about the current environment, believing that there may be more downside to the economy and markets in the near term than upside. As noted, we can now earn a “real” return on most fixed income investments, so we are favoring those over cash, while we wait for better opportunities to expand long-term investments in stocks.