“In fact, the trajectory of America’s public finances is so dire that the most bearish investors talk of the long-term risk of “fiscal dominance”; that interest rates might eventually be set with the goal of controlling the government’s debt-service costs, rather than inflation.” – The Economist, “A surge in global bond yields threatens trouble”, Oct 4 2023
WHAT HAPPENED THIS WEEK THAT MATTERED?
US government dysfunctional but jobs market resilient
Having just breathed a sigh of relief when a US budget compromise was reached by Congress a few days ago, the reality of it being a short term fix followed by the upending of former House Chair McCarthy by a tiny but radical right end of the Republican party is a stark reminder that we will have to do this dance again in a mere six weeks. It’s tiring. And Washington’s dysfunctionality is becoming a larger and larger distraction in the already-fragile global financial marketplace, one more thing we do not need.
Is the current turmoil gripping US politics a sign of a vibrant democracy at work, or the sign of an increasingly polarised and dysfunctional government? I am leaning more towards the latter, and the bond market seems to increasingly be recognising this, too. Oh how I dread the day when the US loses the cover of the almighty US Dollar as the global reserve currency, and the US Treasury bond market losses its platinum, top-drawer status. But this is a topic for another day.
Speaking of markets, I have been fairly adamant that UST yields had peaked around 4.50% on the 10-year a week or two ago, representing an opportunity to extend duration in anticipation of reaping profits on capital appreciation as yields later declined. I expected (and still expect) yields to decline because of a slowing US economy. Also, real rates are have reached near-historic record levels, at least since the GFC, as depicted in the graph below.
With the 10-year UST yield closing at 4.78% on Friday, my inflection point of 4.50% simply looks wrong, certainly for traders that expect instant gratification. I can also understand the dynamics that have some investors talking about 5%, or even 6%, on the 10-year, and I have highlighted these as risks before. However, I am sticking to my guns for now because there are enough diverse headwinds on the horizon which will almost certainly bring the US (and global) economy to its knees, in spite of the resilient jobs market. (As an aside, TIPS might look attractive if you believe real rates are bumping against abnormally high levels.)
The journey for yields on Friday following a much stronger-than-expected jobs report (here) illustrates the volatility in investor sentiment. The 10y traded in a 15bps range intraday (4.71% to 4.86%), with sentiment ranging from “yields are going to the moon and this is bad news” to “a soft landing is more imminent and this is good news.” Go figure.
Also, keep in mind that the economic data we are fed day after day looks back, and we are talking about – or trying to predict – the future. Looking at historical data and past business cycles to extrapolate the future is perfectly reasonable. However, the current environment is like no other, juiced by a combination of nearly-free money from the Fed for most of the post-GFC period and a triple+ dose of mega-fiscal stimulus just after the pandemic. As consumers exhaust their excess savings, oil prices increase, Ukraine-Russia conflict persists, China remains in a funk, auto workers remain on strike, the US government can’t get out of the way of itself, etc., there’s enough friction to make me nervous about future growth, even though US jobs look solid for the time being.
Investment themes in uncertain times
Investment themes that are “front & centre” at the moment include:
AI – The gloss is coming off but undoubtedly AI is a mega-trend. This is recognised by company management teams which often mention the term “AI” as frequently as possible, even if they have no involvement in AI at all at the moment. At times, this borders on comical.
Ozempic – The latest fashionable discussion topic is Ozempic, apparently the answer to obesity and perhaps a broader array of addictions. The euphoria of people eating less is even starting to hit the stocks of snack food and fast-food companies, as well as companies offering similar vices along the same lines (think WMT), should you want to play the other side of this trade. So much for defensive stocks like Pepsi (PEP). As with AI, my fear is that this might be over-hyped (or at least over-priced).
Dividend stocks are getting clobbered as yields pay the price of higher risk-free rates in the UST bond market. That’s another knife in the heart of supposedly defensive sectors like utilities. And does this (meaning rotation out of dividend stocks) help growth stocks, or at least counter-balance the negative effects of a higher discount rate on future cash flows? It sure seems that way, as the NASDAQ is not suffering at all given the latest series of rate rises.
P/E ratio – A broader effect of “higher rates for longer” is the general rotation out of equities and into fixed income, which will likely push stock values down even if earnings surprise on the upside. The TTM P/E ratio of the S&P 500 is 24.3x, and the forward P/E ratio is 19.1x. Here is some context from a Yardeni graph (Oct 5 report here), which suggests the forward P/E is relatively high, and even more fragile if you bolt on higher yields.
What should an investor do?
The two outcomes are the world ends, or it does not. Investors generally fear the former and position accordingly as markets weaken, because they are wired to think that way. At the end of the day, your asset allocation is a personal decision built around your risk tolerance and financial circumstances.
Since this “financial planner-speak” probably doesn’t help you at all with your anxiety, I can at least share what I am doing should it help. As my readers know, I keep a significant amount of core assets in equities simply because historical risk-returns on this asset class are extraordinary over long periods of time if you can tolerate the ups and downs. Having said this, I have been taking money off the equity table gradually much of the year to ensure that that I have enough cash on hand, so that I will not have to sell stocks at beaten-down prices as we drift towards what is sure to be a contentious US election. Within my equity portfolio, I am tilted towards defensive names aside from a few of the tech giants which, although expensive, are very much defensive in my opinion. I have also built a decent allocation in short-dated UST bills and remain invested in some corporate credit via ETFs, although I am looking at this allocation now. Currency-wise, I bought Sterling earlier this week (with US Dollars, because I need Sterling for living expenses), although I do think Sterling could drift lower. You can find more information on my personal portfolio here, and I will be preparing a 3Q update shortly.
MARKETS THIS WEEK
Until Friday’s session, the best market this past week was Chinese equities, simply because the market was closed the entire week for the National Day Golden Week holiday. That’s a sad statement and reflects the poor performance this week of most of the global equity markets I track, as you can see in “The Tables” section below. However, Friday’s US session sparked new life into stocks, surprising since yields gapped up at the open and closed higher on the day. Even more surprising, the typically rate-sensitive tech-heavy NASDAQ composite was the best performing index. One has to admit that US equities – similar to the US jobs market – has shown amazing resiliency as yields have risen over the last couple of weeks.
Although US equities staged a surprising recovery on Friday, US Treasuries did not fare as well, at least if you play intermediate and long-term duration USTs. Both the 7-10 year and the 20+ year total return bond indices lost ground this week, and both are down YtD, with the latter down sharply.
Corporate credit has also shown unexpected resiliency well beyond the time when most analysts predicted it would crack. However, credit finally appears to be feeling the heat, as both yields and credit spreads on corporate bonds widened sharply this week. Data through Thursday shows that USD-denominated high yield credit spreads widened 34bps WoW. Investment grade corporate bonds were not spared, with spreads in that tier wider by 7bps WoW.
The USD continues to grind higher, causing collateral affects into other markets. Oil came sharply off its recent highs, which is a better reflection perhaps of the direction the economy is trending at the moment. The Bank of Japan looks to be intervening at ¥150/US$1, and the pressure is clearly building on the Yen and the Japanese bond market which will likely eventually require some moderation of the bank’s dovish approach.
WHAT'S AHEAD THAT MATTERS?
Things to watch:
UAW strike in the US: volatile situation / ongoing
US government shutdown: 2023-24 budget discussions resolved for six weeks, but will be re-visited and must be resolved by Nov 17th
Student loans are out of forbearance with payments having re-started
Carryover themes: Higher oil prices, stronger US Dollar, China growth (signs property sector is worsening)
Corporate earnings for 3Q23 to start mid-month with the major US banks up first, with JPM, CITI and WFS reporting next Friday (Oct 13) before the open. Magnificent seven are as follows:
Oct 18: TSLA
Oct 24: GOOG, MSFT
Oct 25: META
Oct 26: AMZN
Nov 2: AAPL
Nov 21: NVDA
Economic data this coming week:
US: PPI, CPI and Michigan consumer confidence
Europe: Production data for Germany and the UK, UK retail sales
China: CPI, imports, exports data (all Friday)
Upcoming central bank meetings:
ECB: Oct 26 and Dec 14
Federal Reserve (FOMC): Oct 31/Nov 1; Dec 12-13
Bank of Japan: Oct 30-31 and Dec 18-19
Bank of England: Nov 2 and Dec 14
THE TABLES
The tables below provide detail across various global and US equity indices, the US Treasury market, corporate bonds and various other asset classes.
Global equities
US equities
US Treasuries
Corporate bonds (credit)
Safe haven and other assets
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