Every volatile period in markets has a main character. During this episode it’s been U.S. Treasury yields—but in volatility there is opportunity.
Our Top Market Takeaways for October 09, 2023
Market update
Rate riot
Every volatile period in markets has a main character. During this episode it has been U.S. Treasury yields. Interest rates on 10-year U.S. government debt spiked to a 16-year high of nearly 4.9% last week before settling at 4.8% by the end of the week.
This chart shows the U.S 10-year Treasury yield from 2020 to 2023. It is at 4.1% in March 2003, then increases to 5.3% in June 2007. It then fell to 3.1% in November 2018, and further fell 0.5% in August 2020. It then rose to 4.8% in October 2023.
Treasury yields are like the foundation that the rest of financial markets are built on. When the foundation is shaking, it is hard for other segments to find their footing.
For example, the S&P 500 is more than 6% below its year-to-date high reached on July 31st. U.S. small caps are down nearly 13%. The utilities sector, which is often viewed as a “safe-haven” given its highly consistent revenue profile, is down ~15% (it’s one of the closest things in equity markets to bonds after all).
European equities have been able to hang in a bit better (-5% since the end of July), but are still unnerved by the bond market move (10-year German Bund yields are up by more than 40bps since the end of August).
So what is behind the move in U.S. rates?
Let’s start with the fundamentals.
- Growth: Third-quarter U.S. GDP growth was probably 3% or higher, and there is growing evidence that the durable tailwinds to the economy are being underestimated. The latest revisions to U.S. GDP data released two weeks ago showed that construction spending on manufacturing facilities is up 75% from the pre-pandemic pace. Before the revisions, the data suggested that it was “only” up 40%. This surge is likely due to U.S. industrial policy, and could last for a few more years.
- Monetary policy: Because growth has been resilient, the Federal Reserve is no longer expected to be lowering interest rates anytime soon. The first Fed meeting in which markets think the most likely outcome is a rate cut isn’t until June 2024.
And now for everything else:
- Fiscal deficits: The Treasury is likely to issue more bonds in the future to finance the U.S. government’s deficit, which all else equal should increase bond yields.
- Washington dysfunction: The drama in the House of Representatives does not help dispel the perception that the government lacks the composure to deal with important longer-term issues around its own finances.
- Technical market factors: Positioning, momentum and trend-following strategies could all be exacerbating the moves.
What happens next? We expect rates to stabilize, and eventually fall. Here is why.
- Growth should slow down: We see a few clear headwinds that lead us to expect a deceleration in the fourth quarter: the restart of student loan payments, a reversal in momentum for the housing sector, a potential government shutdown and stagnant capital markets should add weight. Into 2024, higher interest costs will continue to roll through the economy (a dynamic Europe has faced over the last several months). As interest costs take up a higher share of income for corporations and consumers, it diverts their ability to invest in capex, make new hires and spend on discretionary items. Real policy rates are on track to surpass real growth over the next two quarters. In the five other instances we have observed since 1980, growth slowed within three quarters in all but one of them.
- Inflation is still decelerating: U.S. inflation, as measured by the Fed’s preferred metric, hit 3.9% year-over-year in August, a 27-month low. While above the Fed’s target, under the surface we have seen a sharp deceleration. The three-month annualized rate of change in core inflation was 2.2% in August. A slower pace of growth should keep that on track. However, the recent spike in oil prices could act as a near-term risk, with geopolitical events over the weekend top of mind. At the time of writing, crude prices have jumped more than 5% after conflict in Israel stoked supply concerns.
This chart shows the Core PCE Price’s 3 and 12 month annualized change from 2015 to 2023. For the 3 month, it begins at 0.49% in January 2015, and increased to 2.9% in March 2018, it then decreased to -1.1% in May 2020, before rising sharply to 6.6% in June 2021. It stayed at 6.5% in January 2022, then decreased to 2.2% in August 2023. For the 12 month, it starts at 1.2% in January 2015, and increases moderately to 1.7% in January 2021. It then sharply rose to 5.5% in March 2022 and subsequently fell to 3.9% in August 2023.
- The Fed remains on hold: Weaker growth and inflation trending toward target should keep the Fed on hold from here. Historically, yields across the Treasury curve head lower after the end of the Fed’s hiking cycle. We think this pattern will hold; the market just needs clarity that the Fed is actually done. Last Friday’s U.S. labor market data was strong, but wage growth was not a concern. The inflation focus will be on this Thursday’s Consumer Price Inflation release. But if things progress as we expect them to, markets should settle higher. That dynamic is consistent across the pond too, with signs pointing to slowing growth in the euro area and the UK — a point echoed by both economies’ central banks as they may “wait and see” rather than hike more and risk a deeper economic downturn.
Investment implications
What can you do about it?
We see three clear takeaways for investors: Bond yields suggest attractive returns, the equity market dip is providing an entry point, and we still feel great about multi-asset portfolios.
- Bonds look attractive. Treasury bond markets have gone a long way toward pricing out a U.S. recession and compensating investors for additional uncertainty. Markets are assuming that policy rates will remain above 4% for the next 10 years. We think this rate is probably too high. In Europe, signs of weaker growth and decelerating inflation also give us conviction that the peak in yields could be close. This suggests that longer-dated bonds have value.
- As do equities. Earnings expectations are still climbing, while the drawdown has brought valuations back in line with the 10-year average level. From here, we think earnings season (which starts this Friday), positive seasonal trends and stabilizing bond yields will help equities start to rally again. Looking out, we think the chances are better than not that the S&P 500 makes a new all-time high by the middle of next year due to decent earnings growth and valuation expansion as inflation fades further.
This chart shows the S&P 500’s blended forward P/E Ratios from 2011 to 2023. In February 2011, it was at 13.3x. It then fell to 10.4x in August 2011, and rose to 17.3x in March 2015. It continued to rise to 18.2x in January 2018, then fell to 14.1x in December 2018. It then rose sharply to 19.1x in February 2020, plummeted to 13.8x in March 2020, then rose to 23.0x in June 2020. It moderately decreased to 21.4x in December 2021 and fell further to 15.3x in September 2022. It rose again to 19.8x in July 2023, before falling again to 17.8x in October 2023.
There are also lines showing the 10-year average at 17.8x, and the 5-year average at 18.9x.
- Finally, we think that multi-asset portfolios are well positioned to deliver for investors. Equities provide the upside potential in the case that our view plays out, or we end up getting into a bull case where in 2024 equities surge because inflation comes back down to 2% and central banks are lowering interest rates. Meanwhile, fixed income can provide the protection we rely on in case growth slows more dramatically than we expected. If a recession does happen, it seems like interest rates would be poised to fall, and investment grade bonds could rally. If our view plays out, fixed income yields are at levels that suggest healthy total returns even if nothing changes. From here, both parts of the traditional 60/40 portfolios are poised to continue to do their jobs for investors (a global 60:40 stock/bond portfolio has returned more than 5% year-to-date, while a U.S. 60:40 has returned over 7%1).
Market sell-offs can be painful for those who are already invested, but we would encourage those folks to remember their plans. Perhaps the right course of action is to acknowledge that volatility is normal and that you are still on track to reach your goals. For others, a conversation about the options that higher bond yields provide to achieve similar returns with less risk could be appropriate. Yet another group may look at the sell-off in equities and see an opportunity to add exposure to portfolios, as we do.
No matter your and your family’s situation, your J.P. Morgan team is here to discuss opportunities we see in the context of your overall plan.
1 Both the global and U.S. 60:40 portfolios are measured in U.S. dollars.
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