3rd Quarter 2023: Market and Economy

Market and Economy

For decades, the economy and investors have benefited from steadily declining interest rates. But like all good things, this era appears to have come to an end. Due to lingering inflation, interest rates have been pushed higher by the Federal Reserve and seem unlikely to retreat back to previous lows anytime soon.

Historically, the Fed’s pattern has been predictable: Hike rates to bring inflation in check, then quickly lower rates again when some area of the economy inevitably falters. Many analysts, and even some Fed governors, believed July’s hike would mark the peak of the Fed’s tightening cycle, anticipating multiple rate cuts next year. Surprisingly, the US economy has remained resilient despite the Fed raising interest rates by five percentage points since early 2022. Recently, Fed Chairman Jerome Powell signaled a commitment to maintaining elevated rates as long as necessary. There’s even talk of a twelfth rate hike before the year’s end.

The truth is, we’ve been spoiled by four decades of falling interest rates. They couldn’t continue to fall forever, especially after hovering near zero for much of the last decade. This created the conditions for last year’s market selloff. Investors expecting a more normal up-and-down rate cycle were disappointed this quarter as markets dipped across the board. Stocks gave up some of their strong first-half returns, while bonds fell back into the red.

Winston Churchill once said, “When the facts change, I change my mind.” If rates are truly set to remain high and not revert to historically low levels, the financial math changes for investors, business leaders, and consumers. Here’s how financial decision-making will shift:

Valuation Compression: As inflation and rates rise, a dollar earned in the future becomes less valuable. With no inflation, a dollar today will buy the same amount of goods in three years. Low inflation and rates upended valuation models, inflating stock prices post financial crisis. Elevated rates depress the value of stocks. Today’s stock price represents the discounted value of all future earnings. The level of interest rates has a large impact on the present value of that future earnings stream. A higher discount rate results in a lower present value. Much of the stock losses this quarter can be explained more by falling valuations than by tumbling earnings projections.

End of Financial Alchemy: Abnormally low interest rates created some peculiar incentives in corporate boardrooms. Instead of taking the risk of borrowing to fund investments in growth, executives opted instead to buy back company shares with cash from cheap debt, guaranteeing earnings-per-share growth. For example, if a company earns $100 and has 100 shares, investors earn $1 per share. When the company buys back ten shares and continues to earn $100, shareholders now earn $1.11 per share despite the fact that the business hasn’t grown. This kind of financial engineering gave many executives job security but becomes less enticing when borrowing costs spike.

Renewed Importance of Bonds and Cash: With bond yields artificially low and money market funds paying essentially nothing, many investors reached for yield, often taking on added risk. For the first time in over a decade, a high-quality bond portfolio can meaningfully contribute to a balanced portfolio’s returns, potentially offsetting the impact of dampened stock valuations.

Prudent Consumers: The fallout from COVID wasn’t just in health. Ballooning prices have burdened US households. The excess savings from stimulus checks and COVID-induced home confinement have largely been depleted. While consumers will still spend, they may be more thoughtful with their buying decisions going forward.

New Stock Winners and Losers: Near-zero interest rates created surprising stability across the corporate landscape by creating a tide that lifted all corporate boats. Compared to prior decades, the 2010s stood out as having very little change in the leading companies. The majority of the top companies at the decade’s onset remained dominant at its conclusion. That is likely to change.

Many companies teetering on the brink, kept alive solely by cheap debt in recent years, will struggle when refinancing at current rates. On the other side of the coin, healthier companies with strong balance sheets have already seen an earnings boost from interest earned on cash in the bank. In all, corporate spending decisions now face a higher threshold for success, creating more risk for companies aiming to grow earnings. We expect to see more turnover at the top this decade with a larger premium placed on earnings quality.

The New Old Normal

It seems everything I have read focuses on whether the Fed is steering the US economy into an ugly recession or if inflation can fall without a major economic slump. While relevant in the near term, I think the debate misses the fundamental point.

Back in 2009, PIMCO’s Mohamed El-Erian dubbed the Fed’s unconventional low-rate policy—which persisted through 2021—the “New Normal.” Since the start of 2022, markets and the economy have been transitioning back to what could be labelled the “Old Normal,” where higher borrowing costs create tangible effects across the economy and for investors. That doesn’t necessarily have to bring economic gloom. There have been numerous instances when economic growth gained steam even as interest rates were rising. Likewise, there have been periods when the growth rate of the economy slowed, even as rates were falling. The last ten-year period is a good example of that.

Even with higher rates, the economy continues to grow this year. The latest GDPNow estimate by the Atlanta Federal Reserve on October 2 projects the US economy to have grown at a 4.9% rate in the third quarter.

The August Personal Consumer Expenditures Index (Core PCE), which excludes food and energy costs and is the Fed’s favored inflation metric, stood at 3.9%. This is significantly lower than 2022’s peak of 5.6%, but still nearly double the Fed’s 2% target. Thus, elevated interest rates are likely here to stay, at least for the foreseeable future.

Admittedly, this entire commentary is my best guess about the path ahead. The causes for most recessions are rarely the risks you see coming, like a global pandemic. I could be wrong and an overnight recession could push the Fed back to a zero-rate policy. That would actually make our job as investors easier because we have over a decade of experience investing under those conditions. But expecting a return to zero-interest-rate norms may well be a recipe for heartache. If we have entered into a new chapter, both new challenges and new potential lie ahead. As investors, we must adapt our expectations and work to capitalize on the emerging opportunities this “new old” era presents.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.