Goldilocks may have made an appearance at Thanksgiving, finding growth not too slow nor inflation too hot, because U.S. stocks had a stellar rebound from a miserable October. Solid earnings, slowing inflation, and falling Treasury yields seem to have created a just-right mélange to whet investor appetites.
The S&P 500 Index ended the month just shy of a new year-to-date high (ultimately reached in early December), reversing not just October’s, but September’s and most of August’s losses as well. Technology stocks led the market, with the S&P 500 Information Technology sector up 12.9% over the month, followed by Real Estate (up 12.5%) and Financials (up 10.9%). What do all of these sectors have in common? Their sensitivity to interest rates.
With economic growth slowing (but not too much), and inflation decelerating, markets were quick to reassess the outlook for both U.S. Federal Reserve (Fed) policy rates and the current yield of Treasury bonds, where benchmark 10-year yields fell more than 0.5%. The prospect of lower borrowing costs boosts not just growth companies prevalent in the technology sector, but both residential and commercial real estate markets while giving banks something of a breather against the concerns that plagued regional banks earlier this year.
To be clear, economic data released in November supported such a reassement. The jobs market has softened, inflation-adjusted personal spending rose just 0.2% in October1 (though a record $9.8 billion was spent online during Black Friday), the Consumer Price Index (CPI) did not rise in October, and Core CPI (stripping out the more volatile food and energy components) rose just 0.2%.
The Fed, unsurprisingly, unanimously voted to keep interest rates on hold in November. Fed Chairman Powell went a step further when he suggested sustained economic growth may not necessary pass through to higher prices as it had previously. In support of this view, he credited easing bottlenecks in the supply chain, a rise in labor supply, and overall productivity.
“Goldilocks and the Three Bears” may be a fairy tale, and thus a healthy portion of skepticism is appropriate, but November’s economic data and the market’s response suggest Goldilocks would have felt right at home last month, with no grumpy bears in sight.
Outlook: The long period of rising U.S. policy rates will likely end with 2023. But the toll that higher rates extract from economic growth has a lagged effect, and we believe the impact will become steadily more apparent as we head into 2024.
Should the economy slow more abruptly than the market currently expects, the Fed could relent and begin to talk about lowering interest rates. While the recent inflation data, if sustained, might support such an outcome, we believe the Fed will be reluctant to embrace lower rates without compelling evidence inflation will reach its target. We believe the Fed, which has the difficult task of balancing the so-called “dual mandate” of simultaneously targeting lower inflation and higher employment, currently favors the former and will do so until they are confident inflation has stabilized at appropriate levels.
In this environment, and despite November’s strength, we continue to think bonds broadly can be compelling long-term investments. Short-term securities issued by either the U.S. Treasury or high-quality companies offer attractive yields given our expectation that the Fed is likely to keep short-term interest rates high into next year. While longer-dated Treasury bonds have been volatile recently, they offer the opportunity to lock in today’s yields for the length of the bond. If we are right that Treasury yields have likely peaked, then the total return realized in longer-dated bonds could be impressive as the capital appreciation gained from any decline in rates is added to the already attractive yield earned just by holding them.
High-quality corporate bonds also offer attractive yields, in our view, insofar as the underlying Treasury yield remains high and the spread offered over that yield remains attractive. While this is most apparent in the high-yield (below investment grade) market, we are not convinced their current yields adequately compensate for the risks that could emerge in a slowing economy. Investment-grade corporate bonds, however, are more likely to weather any economic storms.
While the recent strength in both stocks and bonds could well continue, we expect periods of optimism will be balanced by periods of skepticsm, keeping volatility relatively high during the transition to a lower growth, lower inflation, environment. While the short-term effects of volatility can be alternatingly elating and painful, these same periods can also offer opportunities for actively managed portfolios and investors who have heeded our words of caution and retained some flexibility to add risk when valuations become attractive.