The US stock and bond markets have finally capitulated to a “higher-for-longer interest rate” scenario. For the longest time, investors remained convinced that the US Federal Reserve would cut interest rates sooner rather than later, even as Fed officials repeatedly insisted otherwise. (Because of this, long-term interest rates lagged short-term rates, resulting in the much talked about inverted yield curve). Over the past few weeks, however, something broke. As the job market and economy continued to show remarkable resilience, which would most likely result in the Fed keeping interest rates high longer than expected, expectations are now shifting, rapidly.
We have explained in previous articles why cash, which has been trash for more than a decade, is now king. With short-term yields well above 5%, cash and short-term money market funds are, once again, legitimate investment options. Real returns (after inflation) are positive and, with minimal risks, this asset class has become increasingly harder for portfolios to ignore. And it is sucking money out of risky assets, which were the TINA (there is no alternative) investment when interest rates were low and falling. We think the era of extreme low interest rates has ended.
Investors are starting to price in the rising probability of this new reality — by demanding higher returns on longer-dated Treasuries. Yields for the benchmark 10-year US Treasury broke above 4.8% while the 30-year bonds surged above 5%, the highest levels since 2007, just before the global financial crisis (GFC).
The resulting bond market rout — bond prices are inversely correlated to yields (falling as yields rise) — spilled over into the stock market. And sent stock prices tumbling. Recall that the value for a stock is equal to its discounted future cash flows (profits). Mathematically, a higher discount rate (interest rate) will translate into lower value (price), as future earnings are now worth less.
We think interest rates may be near peak but will remain elevated for some time, which is more bad news for a stock market that has been priced for perfection.
While short-term interest rates are largely determined by monetary policy, yields for longer-term Treasuries are driven by market demand and supply. In addition to “Fed talk”, we suspect the recent sharp upward recalibration in expectations for longer-term Treasuries yields is also due to both rising supply (the US government’s growing funding needs) and lower demand, including from the Fed and other central banks.
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Since the GFC, the Fed has been a big buyer of Treasuries under its quantitative easing (QE) programmes, to inject liquidity into the financial system. But it is now doing the reverse, shrinking its balance sheet or quantitative tightening (QT) — effectively taking away one big, consistent source of demand for Treasuries.
Meanwhile, geopolitics and the weaponisation of the US dollar (in the aftermath of Russia’s invasion of Ukraine) have likely dampened global demand for Treasuries. For instance, China (the second-largest holder of US Treasuries in the world, after Japan) has been paring its holdings quite aggressively in recent years while Japan’s holdings too have fallen since February 2022 (see Chart 1). We have previously written about the risks to Treasuries demand and yields if and when the Bank of Japan (BoJ) finally exits its yield curve control and negative interest rate policies. Indeed, Japan’s domestic yields have been inching higher this year, after the BoJ widened its target range slightly. That has prompted institutional investors, including pension and insurance funds, to repatriate overseas funds and reinvest in the domestic market. And evident also from the likes of Warren Buffett investing in Japanese equities.
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As a result, real yields on the 10-year Treasury have risen to around 2.4% currently, well above the long-term average in the last two decades — and may well remain high, even if inflation and inflation expectations decline (see Chart 2).
If the era of extremely low interest rates is indeed over, then bonds will eventually (after prices stabilised) become attractive investments, especially if the US economy heads into recession. And, if so, this would take even more liquidity away from stocks. Again, bad for stocks.
Corporate margins and profits about to head lower?
Over time, stock prices are driven by underlying earnings. The US stock market has been the standout performer for more than a decade — underpinned by rising earnings. The S&P 500 Total Return Index (including dividends) delivered a 12.7% compound annual growth rate (CAGR) between 2012 and 2022 (see Chart 3).
Profits growth was due, in part, to cheap and cheaper borrowings, which drove investments and economic growth. Consider this: Real yields on the 10-year Treasury averaged 0.6% in the past decade, compared with average gross domestic product (GDP) growth of 2.1%. Importantly, margins and profits rose sharply after the Covid-19 pandemic, since 2021 (more on this later). But this will change with the reversal of the secular decline in interest rates, a trend that has persisted for the past 40 years.
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For starters, higher borrowing costs will hurt earnings for leveraged companies, such as utilities — and it will hurt investments. Zombie companies sustained by “free money” will fail, with its consequential effect on banks and investors. More worryingly, higher yields are raising concerns anew about the sustainability of high government budget deficits and indebtedness.
In the world of secular interest rate decline, rising deficits and debt levels are less of a burden — given falling debt servicing costs. Case in point: Debt servicing as a percentage of GDP remained low from a long-term historical perspective, even as government deficits and debts grew (see Chart 4). This, in turn, enabled larger government budgets — and deficit spending fuelled corporate profits.
Remember the Levy-Kalecki profit equation (see Chart 5)? As we wrote previously, aggregate domestic profits for the US business sector as a whole have risen steadily over time (blue line). Since the GFC, profits have been driven by private sector investments, dividends and, increasingly, government deficit spending — all of which inject cash into the circular flow in the economy (and into the business sector). In particular, government spending surged in 2020-2021, in response to the pandemic.
The sharp jump in corporate profits during the pandemic years was due, in large part, to significantly higher margins (see Chart 6) — the result of corporate greed for profits as explained in our recent article (“Greedflation, stock prices and the policy implications” published in The Edge Malaysia dated Sept 25, 2023). The massive fiscal spending — free money to households — and near-zero interest rates, coupled with supply disruptions, gave companies pricing power, allowing them to raise prices over and above cost increases. And consumers were willing to pay because the handouts were basically “free money”.
Near-zero interest rates boosted stock valuations (in terms of PE multiples) and the higher profits and excessive liquidity drove stock prices to record highs, which then attracted even more funds (domestic and global). Positive wealth effect from the stock market further boosted consumption and investments, in a positive feedback loop.
Higher interest rates will now have the opposite effects. As a larger portion of the fiscal budget goes to servicing debts, less will be spent on funding programmes (less money for the economy). In effect, this will take away one of the main drivers of economic and corporate profits growth. Currently, analysts expect 2024 earnings for S&P 500 companies to grow by over 12%, on the back of 5.6% sales growth. We think this may be too bullish.
If the interest rate is near peak, then the economy must also be weakening. If it is not, then interest rates will have to go even higher. Our premise is that the Fed will not — and cannot — give up on its 2% inflation target. That means slower demand growth, maybe even falling sales. Under this environment, companies must start giving up their “abnormal” margins and move back towards marginal cost pricings, to remain competitive and survive the downturn.
With inflation still well above its 2% target, the Fed is less likely to cut rates quickly, as it did at the outset of the GFC and pandemic. The combination of higher borrowing costs and weakening demand will, we think, inevitably lead to lower margins and profits — and stock prices.
Yes, there is a lot of hope that generative artificial intelligence (AI) will more than offset all the above-mentioned headwinds. That the resulting productivity gains will supercharge growth and profits, and accordingly improve government revenue and fiscal position. But all these are far from certain. We do not know how fast generative AI can be monetised or to what extent. Given the heightened uncertainties, things could go awry pretty quickly.
We have previously explained why the effects of the Fed’s sharp interest rate hikes have been muted thus far, including fixed-rate long-term mortgages and pandemic excess savings (now largely depleted) for households. But at some point, the cumulative interest rate hikes and higher-for-longer borrowing costs as well as higher prices must have some dampening effect on consumption. Case in point: Total bank credit is falling sharply, as higher borrowing cost bites (lower demand from businesses and households) while banks have also tightened lending standards. Historically, shrinking bank credit often precedes recession (see Chart 7).
Let us be clear: We are contrarian, and we see a global recession before 2025. We are certainly bearish on equities, and we have articulated for some time now that cash will be king. Hence, we think investors can afford to be patient, given the current risk-reward proposition for stocks. Wait for better clarity. After all, the yield on cash is very attractive at the moment.
Our only stockholding in the Malaysian Portfolio, Insas, gained 2.3% last week, boosting total portfolio returns to 158.2% since inception. The portfolio is outperforming the benchmark FBM KLCI, which is down 21.5%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
