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Per Stirling Capital Outlook – October

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In the 1990s, political strategist James Carville famously noted: “I used to think that, if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.”

If you do not believe it, just ask former British Prime Minister Liz Truss, who was forced to resign her position after only forty-five days, after the bond market threw a fit in response to her budget proposal that featured tax cuts and spending increases (essentially “Reaganomics”), and forced the Bank of England to introduce massive purchases of government debt, in order to avoid a major solvency crisis in Britain’s pension system.

The bond market response was particularly violent, as Truss’ budget proposals were almost certain to exacerbate Britain’s 13.2% inflation rate, and would have counteracted the Bank of England’s efforts to bring inflation under control.

Soaring interest rates have also forced the Bank of Japan into massive currency interventions, as a means of protecting the value of the yen and keeping their 10-year government bond yield at or below their 0.25% target.  (Japan is employing a likely ill-fated monetary policy called “yield-curve-control”, where the government is aggressively buying Japanese government bonds as a means of artificially depressing interest rates.)

Importantly, while the world’s central banks get most of the headlines, and while there is normally a very high correlation between the rates set by the central banks and those set by the markets, the central banks only control ultra-short-term interest rates.

In contrast, the vast majority of interest rates around the world are set by the bond markets, which is as of critical importance, as interest rates may be the single most important determinant of the future outlook for stocks, bonds, real estate, and even the domestic and global economies.  Sometimes the bond market follows the lead of the central banks, and sometimes the central banks follow the lead of the bond markets.

One of the things that has made 2022 so unique is that it has not featured just one or two central banks pushing rates higher.  In the past three months alone, over 90% of the world’s 13 developed-market central banks have raised rates, and not just by small increments. 

Over those three months, these thirteen central banks have raised rates by a cumulative 15.25%, or an average of over 1.17% per bank.  This is an average annual rate increase per bank of a stunning 4.69%.

What makes this global (aside from Japan) rise in rates even more striking this year is the fact that many global bonds that are now yielding 1.9% to 4.5% were yielding less than 1% (and in numerous cases less than 0%) less than a year ago.

It is little wonder that the International Monetary Fund projects that almost 35% of the world’s economies will fall into recession next year, and that the G-20 just proclaimed that “The global economic situation has become more and more challenging.  The world is in a dangerous situation.”1

Many of the world’s largest economies, including that of both the United States and Europe as a whole are among those expected to enter into a recession next year.  Indeed, Europe is likely already in recession.

As you might suspect, higher interest rates are as negative for most financial markets as they are for economies, and that low and/or falling rates have the exact opposite impact.

Higher rates depress the prices of bonds, as bond prices virtually always move in the inverse of interest rates. 

This is particularly true of higher-quality bonds, where the risk of default is negligible.

Higher rates also depress stock prices by both hurting corporate profits and lessening the value that investors assign to each dollar of corporate earnings (known as “multiples compression”).  Higher rates also create competition for equities by making the yield on fixed income investments more attractive to investors (something that they have arguably not been over recent decades).

It should therefore be no surprise that 2022 has produced the worst ever initial three quarters for bonds and the fourth worst start of the year for equities since 1926. 

Similarly, 2022 has been only the second time in history (the other being 1931) when both the domestic stock market and the domestic bond market have each experienced three consecutive quarters of losses.

Higher interest rates are largely responsible for the losses in both the stock and bond markets, and it is the fact that both asset classes have declined both substantially and in unison that has caused so much pain for investors in 2022.

Rather than one asset class offsetting some of the risk and volatility of the other, which is almost always the case, this year there have been almost no benefits of portfolio diversification, whether it be in bonds, stocks, or even real estate.

Indeed, higher interest rates may have an even greater and more immediate impact on real estate prices than on stocks and bonds, as mortgage rates can sometimes have as big an influence on the size of mortgage payments as the price of the property itself.

There is an old saying that “central banks hike rates until they break something”, and there are already a great many things being “broken”, ranging from foreign currencies and domestic and foreign debt (including emerging market sovereign bond defaults), to global stock markets, the global economy, and the housing market. 

In many regards, these are examples of collateral damage being inflicted on innocent bystanders.  That said, we do not think that the central banks are displeased to see this year’s fall in the value of financial assets, due to the decline’s dampening impact on inflation.

From our perspective, the central banks, and by correlation, the bond markets, are indeed trying to “break something”, and that is the back of inflation.  The Federal Reserve arguably also has a secondary target, the labor market, where inflation is being exacerbated by a massive imbalance between the number of jobs available and the number of people looking for work.

The Fed’s objective is not to cause people to lose their jobs.  They just want to get rid of the “excess” jobs that have gone unfilled, and which are encouraging behavior that is worsening wage inflation. This is an area where the Fed’s policies are already starting to have the desired effect.  As recently as July, there were two jobs available for every available unemployed worker.  As of the August report, that mismatch was reduced to 1.7 jobs per every available worker.

In addition, while the back of the primary target, inflation, is not yet broken, there are an increasing number of encouraging signs, ranging from improving supply chains to sharp declines in expectations for future inflation. 

Perhaps of equal  importance is the backward-looking and lagging nature of the government’s inflation measures.  The most lagging component, because of the data being collected only twice per year, is the housing data, which is also the most important, as it represents 32.8% of the Consumer Price Index and 42.0% of the Core (ex-food and energy) Consumer Price Index.  Importantly, if you look at real-time data, which is not yet reflected in the government’s inflation numbers, there is growing evidence that the rate of increase in this important component is already turning sharply lower.  Of note, in the U.S., shelter inflation is based on rent and presumed rent rather than house prices.

While this in no way suggests that the Fed is about to reverse course and start cutting rates, it is the first time that fundamental news is starting to line up with Fed guidance and market expectations, and may at least be opening the door to less aggressive rate hikes by the Fed.

This potentiality gained some credibility last week when Federal Reserve Bank of San Francisco President Mary Daly said “I think the time is now to start talking about stepping down. The time is now to start planning for stepping down”.2 While President Daly has a well-earned reputation as a dove, this is one of the few recent instances of a Fed President advocating a less aggressive stance.

Even more importantly, on October 21st, the Wall Street Journal’s Chief Economic Correspondent, Nick Timiraos, reported that the Fed governors were in the process of deciding whether to aim for a smaller hike in December, and how to communicate that potential change to the market.3 Of note, Mr. Timiraos is not just any reporter.  He has become known as “the Fed Whisperer”, because there is an established history of the Fed leaking stories to him whenever it wants to provide “unofficial” forward-guidance to the markets.

Even the minutes from the last Fed meeting hinted at the idea of pausing its rate hiking program, when it said: “Many participants indicated that, once the policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time until there was compelling evidence that inflation was on course to return to the 2% objective”.4

All things considered, we are increasingly of the opinion that the Federal Reserve is approaching the end of its rate hiking program, and that the last of the rate hikes are likely to take place no later than the first or second quarter of next year.  In addition to the fact that such a pause would likely prove highly beneficial to both bond prices and real estate values, equity investors might take some comfort from the fact that, in four of the past eight Fed tightening cycles, the stock market bottomed once the Fed paused their rate hikes, if not before.  In the other four instances, the bear market did not reach its lows until after the first rate cut by the Fed, which we suspect is likely still about a year away.

Another justification for increased optimism on the equity front are valuations which, although not nominally inexpensive, have fallen to levels that have historically been associated with one and five-year forward average annual returns of around 10%.  Of note, in the middle of last year, valuations were so high that they actually suggested 10-year average annual returns of 0%, which seems rather prescient in light of this year’s substantial decline.

While the past is not necessarily prologue, there are some other lessons from history that might justify further optimism, including the fact that, once the S&P 500 declines by at least 25%, which it now has, the returns over the following 1, 3, 5 and 10 years have tended to be extraordinarily strong. 

In addition, seasonal tendencies are very bullish.  According to Barron’s “Since 1961, November through April have brought an almost 3,000% cumulative return on the S&P 500 in inflation-adjusted terms, according to Stifel. Those gains are a smidgen below the S&P 500’s cumulative return overall for those same six decades. In contrast, the months of May through October for the same period have had a cumulative return of only 14%.5

We have maintained over the past several months that the equity markets are in the process of putting in a bear market bottom, and we are still of that opinion.  It is potentially encouraging that stocks seem to be finding support around previous lows, despite the fact that interest rates have continued to move sharply higher.  This is a potential sea change as, until recently, there has been a very high and remarkably consistent correlation between interest rates moving higher and stock prices moving lower.

While we do not believe that we have necessarily reached a bottom yet, we are seeing a growing array of encouraging signs.  Further, if we are correct in our belief that interest rates are likely approaching their peaks, it seems reasonable that equities (at least in the U.S.) have already suffered through a significant majority of their likely losses, and that investors who start taking advantage of the opportunities created by this year’s mayhem are likely to look pretty smart one, three, five and ten years from now, even if they may feel a little foolish a month or a quarter from now. 

Of note, our opinion on bonds is very similar.  While we do not believe that the ultimate lows are yet in place, we do think that they are likely in sight.  We also believe that current yields are reasonably attractive, and that the bond market will even allow opportunities for capital gains over coming years, as the Fed brings inflation under control, and yields gradually meander lower.

There appears to be a light at the end of the tunnel and, for a change, it looks much less like an oncoming train.


Advisory services offered through Per Stirling Capital Management, LLC. Brokerage services and securities offered through B. B. Graham & Co., Inc., member of FINRA/SIPC. Per Stirling Capital Management, LLC, and B. B. Graham & Co., Inc., are separate and otherwise unrelated companies.
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Image 1 “Interest rate”, by Nick Youngson CC BY-SA 3.0 Pix4free