The bright side of higher interest rates ☀️
Plus a charted review of the macro crosscurrents 🔀
Stocks ticked higher last week, with the S&P 500 rising 0.5% to close at 4,308.50. The index is now up 12.2% year to date, up 20.4% from its October 12 closing low of 3,577.03, and down 10.2% from its January 3, 2022 record closing high of 4,796.56.
As we discussed here last week, there continues to be a deluge of unsettling headlines about everything ranging from volatile energy prices to ongoing government dysfunction to uncertainty about the path for monetary policy.
What’s going on?
While rising interest rates are usually considered a headwind, there’s some counterintuitive nuance to the narrative.
First, many companies refinanced much of their debt over the past three years, locking in very low interest rates. So as market interest rates have risen, the effective interest rate corporations are paying today remains low.
Similarly, the vast majority of outstanding mortgages have a locked-in rate that’s lower than the current market rate. So for many consumers, the financing cost of their largest liability has been unchanged.
“… It is effectively as if the Fed cut rates. Why? Because corporates took advantage of QE to term out borrowing at record-low rates and are now earning 5%+ interest on their cash. A similar dynamic can be seen with households: US aggregate household net interest receipts are still where they were before this hiking cycle started as the interest earned on cash has matched payments on borrowings.“
It’s counterintuitive but as Saravelos’ chart shows, the net interest corporations have been paying has actually declined as interest rates have risen thanks to the higher interest income.
To be clear, there are still businesses and consumers who are actively borrowing today at interest rates that are much higher than they were years ago.
And should today’s elevated rates persist, over time more borrowers could find themselves facing more onerous debt costs as they refinance at higher rates.
Of course, it’s also possible that interest rates come down. After all, there’s little about the future that is certain.
The bottom line: Rising interest rates are currently having a limited negative impact on businesses and consumers as a whole. For many, it’s actually been a net positive.
A quick note about excess savings 💸
Excess savings — the extra cash that consumers piled up since February 2020, thanks to a combination of government financial support and limited spending options during the pandemic — has been a key driver of the economic recovery.
But as time has passed and these savings have been drawn down, the concept of excess savings has become less relevant. (Also, more comprehensive measures of household finances suggest cash levels are very high.)
Having said all that, new government data suggests these excess savings balances have actually been much higher than previously estimated. From Wells Fargo (emphasis added):
The benchmark revisions to the National Accounts last week caused some pretty big changes to our measure of excess savings again. Essentially, the data now suggest there is $1.1T remaining in excess savings through August, whereas the previous data suggested only about $339B remaining through July. This all comes down to our pre-pandemic baseline shifting from a 9.1% saving rate in January 2020 down to 7.2%. Since our baseline of comparison is now lower, the excess today looks higher because we are not as far from that base as we were. We have thus “spent it down” at a slower rate. The data now suggest there is more than three times the amount the pre-revised data suggested (~$340B) through July.
The Wells Fargo economists also argue that “it is not sensible to hang your hat on an estimate subject to such comically large revisions.“ They also point to the more comprehensive measures of checking and savings balances, noting the readings are “clearer and suggests households still have excess liquidity.”
Nevertheless, the idea that there continues to be a lot of excess savings helps us understand why consumer spending continues to be so resilient.
Related from TKer:
Reviewing the macro crosscurrents 🔀
There were a few notable data points and macroeconomic developments from last week to consider:
🔥 The labor market is still hot. According to the BLS’s Employment Situation report released Friday, U.S. employers added 336,000 jobs in September, the 33nd straight month of gains. While the pace of job growth has generally been cooler, the numbers continue to confirm an economy with robust demand for labor.
Employers have now added a whopping 2.3 million jobs since the beginning of the year. Total payroll employment is at a record 156.9 million jobs.
The unemployment rate — that is, the number of workers who identify as unemployed as a percentage of the civilian labor force — was 3.8% during the month. While it’s above its cycle low of 3.4%, it continues to hover near 53-year lows.
For more on the labor market, read: The hot but cooling labor market in 16 charts 📊🔥🧊
📉 Wage growth cools. Average hourly earnings rose by 0.21% month-over-month in September, down slightly from the 0.24% pace in August. On a year-over-year basis, this metric is up 4.15%, a rate that’s been cooling but remains elevated.
For more on why the Fed is concerned about high wage growth, read: The complicated mess of the markets and economy, explained 🧩
📈 Job switchers get better pay. According to ADP, which tracks private payrolls and employs a different methodology than the BLS, annual pay growth in September for people who changed jobs was up 9% from a year ago. For those who stayed at their job, pay growth was 5.9%.
For more on the implications of cooling inflation, read: The bullish 'goldilocks' soft landing scenario that everyone wants 😀
💼 Job openings tick up. According to the BLS’s Job Openings and Labor Turnover Survey, employers had 9.61 million job openings in August. While this remains elevated above prepandemic levels, it’s down from the March 2022 high of 12.03 million.
And yes, August’s print was an uptick from July’s. But the trend still appears to be downward.
For more on how data can be noisy, read: The markets and the economy are 'full-on Monet' 🖼️
During the period, there were 6.36 million unemployed people — meaning there were 1.51 job openings per unemployed person. This continues to be one of the most obvious signs of excess demand for labor.
For more on job openings, read: Were there really twice as many job openings as unemployed people? 🤨
👍 Layoffs remain depressed, hiring remains firm. Employers laid off 1.68 million people in August. While challenging for all those affected, this figure represents just 1.1% of total employment. This metric continues to trend below pre-pandemic levels.
Hiring activity continues to be much higher than layoff activity. During the month, employers hired 5.86 million people.
For more on why this metric matters, read: Watch hiring activity 👀
💼 Unemployment claims tick up. Initial claims for unemployment benefits increased to 207,000 during the week ending September 20, up from 205,000 the week prior.While this is up from a September 2022 low of 182,000, it continues to trend at levels associated with economic growth.
👎 Services surveys signal cooling growth. The ISM’s September Services PMI reflected growth in the sector, but at a decelerating pace.
From S&P Global’s September Services PMI report: “The final PMI data for September add to indications that the US economy has started to cool again after a resurgence of growth earlier in the summer. Inflationary pressures in the service sector meanwhile remain uncomfortably sticky. The biggest change in recent months has been the waning in demand for consumer services, such as travel, tourism and recreation, along with a slump in financial services activity…“
🏭 Manufacturing surveys improve. The ISM’s September Manufacturing PMI reflected contraction in the sector, but signaled the contraction was easing and is above breakeven levels for the economy.
Key ISM subindexes improved, including new orders, production, and employment. Importantly, prices declined significantly.
Similarly, S&P Global’s September Manufacturing PMI also improved. From the report: “Output reversed some of the loss seen in August as higher employment and improved supply availability helped factories fulfill backlogs of orders.“
It’s worth remembering that soft data like the PMI surveys don’t necessarily reflect what’s actually going on in the economy.
For more on this, read: What businesses do > what businesses say 🙊
🔨 Construction spending rises. Construction spending rose 0.5% to an annual rate of $1.98 trillion in August.
For more on broad measures of the U.S. economy, read: Still waiting for that recession people have been worried about 🕰️
💳 Spending is holding up, according to September card data. From BofA: “Total card spending per HH was up 1.8% y/y.“
From JPMorgan Chase: “As of 30 Sep 2023, our Chase Consumer Card spending data (unadjusted) was 2.3% above the same day last year. Based on the Chase Consumer Card data through 30 Sep 2023, our estimate of the US Census September control measure of retail sales m/m is 0.14%.“
For more on the resilience of the consumer, read: Don't underestimate the American consumer 🛍️
⛽️ Gas prices tick lower. From AAA: “The decline in pump prices accelerated a bit since last week, with the national average falling seven cents to $3.76. The primary culprits are slack demand and the falling cost of oil, which has shaved more than $10 and is hovering near $82 per barrel.“
For more on energy prices, read: The other side of the surging oil price story 🛢
📈 Mortgage rates continue to rise. According to Freddie Mac, the average 30-year fixed-rate mortgage rose to 7.49%, the highest level since December 2000. From Freddie Mac: “Mortgage rates maintained their upward trajectory as the 10-year Treasury yield, a key benchmark, climbed. Several factors, including shifts in inflation, the job market and uncertainty around the Federal Reserve’s next move, are contributing to the highest mortgage rates in a generation. Unsurprisingly, this is pulling back homebuyer demand.“
Remember, this is the market rate. Most borrowers borrowed when rates were much lower, and so the effective average rate among all outstanding borrowers remains low.
For more, read: The U.S. housing market has gone cold 🥶
🚗 Used car prices fall. From UBS (via Notes): “JD Power Used Car Guide retail valuations dropped substantially in September.“
⛓️ Supply chain pressures tighten a little. The New York Fed’s Global Supply Chain Pressure Index1 — a composite of various supply chain indicators — ticked up in September, but remains below levels seen even before the pandemic. It's way down from its December 2021 supply chain crisis high.
For more on the supply chain, read: We can stop calling it a supply chain crisis ⛓
📈 Near-term GDP growth estimates remain positive. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 4.9% rate in Q3.
For more on the forces bolstering economic growth, read: 9 reasons to be optimistic about the economy and markets 💪
Putting it all together 🤔
This comes as the Federal Reserve continues to employ very tight monetary policy in its ongoing effort to bring inflation down. While it’s true that the Fed has taken a less hawkish tone in 2023 than in 2022, and most economists agree that the final interest rate hike of the cycle has either already happened or is near, inflation still has to cool more and stay cool for a little while before the central bank is comfortable with price stability.
So we should expect the central bank to keep monetary policy tight, which means we should be prepared for tight financial conditions (e.g., higher interest rates, tighter lending standards, and lower stock valuations) to linger. All this means monetary policy will be unfriendly to markets for the time being, and the risk the economy slips into a recession will be relatively elevated.
At the same time, we also know that stocks are discounting mechanisms, meaning that prices will have bottomed before the Fed signals a major dovish turn in monetary policy.
Also, it’s important to remember that while recession risks may be elevated, consumers are coming from a very strong financial position. Unemployed people are getting jobs, and those with jobs are getting raises.
Similarly, business finances are healthy as many corporations locked in low interest rates on their debt in recent years. Even as the threat of higher debt servicing costs looms, elevated profit margins give corporations room to absorb higher costs.
At this point, any downturn is unlikely to turn into economic calamity, given that the financial health of consumers and businesses remains very strong.
And as always, long-term investors should remember that recessions and bear markets are just part of the deal when you enter the stock market with the aim of generating long-term returns. While markets have had a pretty rough couple of years, the long-run outlook for stocks remains positive.
For more on how the macro story is evolving, check out the the previous TKer macro crosscurrents »
TKer’s best insights about the stock market 📈
Here’s a roundup of some of TKer’s most talked-about paid and free newsletters about the stock market. All of the headlines are hyperlinked to the archived pieces.
The stock market can be an intimidating place: It’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes in it very quickly. But it’s also a place where thoughtful investors have long accumulated a lot of wealth. The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
Passive investing is a concept usually associated with buying and holding a fund that tracks an index. And no passive investment strategy has attracted as much attention as buying an S&P 500 index fund. However, the S&P 500 — an index of 500 of the largest U.S. companies — is anything but a static set of 500 stocks.
For investors, anything you can ever learn about a company matters only if it also tells you something about earnings. That’s because long-term moves in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings. Over time, the relationship between stock prices and earnings have a very tight statistical relationship.
Investors should always be mentally prepared for some big sell-offs in the stock market. It’s part of the deal when you invest in an asset class that is sensitive to the constant flow of good and bad news. Since 1950, the S&P 500 has seen an average annual max drawdown (i.e., the biggest intra-year sell-off) of 14%.
There’ve been lots of talk about the “yield curve inversion,” with media outlets playing up that this bond market phenomenon may be signaling a recession. Admittedly, yield curve inversions have a pretty good track record of being followed by recessions, and recessions usually come with significant market sell-offs. But experts also caution against concluding that inverted yield curves are bulletproof leading indicators.
Every recession in history was different. And the range of stock performance around them varied greatly. There are two things worth noting. First, recessions have always been accompanied by a significant drawdown in stock prices. Second, the stock market bottomed and inflected upward long before recessions ended.
Since 1928, the S&P 500 generated a positive total return more than 89% of the time over all five-year periods. Those are pretty good odds. When you extend the timeframe to 20 years, you’ll see that there’s never been a period where the S&P 500 didn’t generate a positive return.
At some point in the future, we’ll learn a new bull market in stocks has begun. Before we can get there, the Federal Reserve will likely have to take its foot off the neck of financial markets. If history is a guide, then the market should bottom weeks or months before we get that signal from the Fed.
While a strong dollar may be great news for Americans vacationing abroad and U.S. businesses importing goods from overseas, it’s a headwind for multinational U.S.-based corporations doing business in non-U.S. markets.
The stock market sorta reflects the economy. But also, not really. The S&P 500 is more about the manufacture and sale of goods. U.S. GDP is more about providing services.
…you don't want to buy them when earnings are great, because what are they doing when their earnings are great? They go out and expand capacity. Three or four years later, there's overcapacity and they're losing money. What about when they're losing money? Well, then they’ve stopped building capacity. So three or four years later, capacity will have shrunk and their profit margins will be way up. So, you always have to sort of imagine the world the way it's going to be in 18 to 24 months as opposed to now. If you buy it now, you're buying into every single fad every single moment. Whereas if you envision the future, you're trying to imagine how that might be reflected differently in security prices.
Some event will come out of left field, and the market will go down, or the market will go up. Volatility will occur. Markets will continue to have these ups and downs. … Basic corporate profits have grown about 8% a year historically. So, corporate profits double about every nine years. The stock market ought to double about every nine years… The next 500 points, the next 600 points — I don’t know which way they’ll go… They’ll double again in eight or nine years after that. Because profits go up 8% a year, and stocks will follow. That's all there is to it.
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
According to S&P Dow Jones Indices (SPDJI), 59.7% of U.S. large-cap equity fund managers underperformed the S&P 500 during the first half of 2023. As you stretch the time horizon, the numbers get more dismal. Over a three-year period, 79.8% underperformed. Over a 10-year period, 85.6% underperformed. And over a 20-year period, 93.6% underperformed.
S&P Dow Jones Indices found that funds beat their benchmark in a given year are rarely able to continue outperforming in subsequent years. For example, 318 large-cap equity funds were in the top half of performance in 2020. Of those funds, 39% came in the top half again in 2021, and just 5% were able to extend that streak through 2022. If you set the bar even higher and consider those in the top quartile of performance, just 7% of 156 large-cap funds remained in the top quartile in 2021. No large-cap funds were able to stay in the top quartile for the three consecutive years ending in 2022.
Picking stocks in an attempt to beat market averages is an incredibly challenging and sometimes money-losing effort. In fact, most professional stock pickers aren’t able to do this on a consistent basis. One of the reasons for this is that most stocks don’t deliver above-average returns. According to S&P Dow Jones Indices, only 24% of the stocks in the S&P 500 outperformed the average stock’s return from 2000 to 2022. Over this period, the average return on an S&P 500 stock was 390%, while the median stock rose by just 93%.
Here’s some info on how the index is constructed, according to the NY Fed: “We use the following subcomponents of the country-specific manufacturing PMIs: ‘delivery time,’ which captures the extent to which supply chain delays in the economy impact producers—a variable that may be viewed as identifying a purely supply-side constraint; ‘backlogs,’ which quantifies the volume of orders that firms have received but have yet to either start working on or complete; and, finally, ‘purchased stocks,’ which measures the extent of inventory accumulation by firms in the economy. Note that in case of the U.S., the PMI data start only in 2007, so for the U.S. we combine the PMI data with those from the manufacturing survey of the Institute for Supply Management (ISM).“