Markets at Ease…For Now

December 7, 2023

Source: Bloomberg Source: Bloomberg

Like a drill sergeant shouting “Ten-Hut” (Attention!), interest rates have certainly caught the attention of market participants over the past few months. While we all know that interest rates play a critical role in valuations across the income investable universe, it has become clear that the dramatic swings in the U.S. 10-year Treasury yield from approximately 4% to 5% and back again have commanded more of an outsized influence than usual. 

The income investable universe has undergone quite a massive shift in sentiment from October to November, directly tied to swinging interest rates and fears of overtightening and then the sharpest loosening of financial conditions in decades. As the adage goes, "There are decades where nothing happens; and there are weeks where decades happen." Over the past few weeks, we had decades happen, and it is apparent in many technical indicators. 

Based on movements in the U.S. 2-year Treasury yield, the markets have been here twice in the past year in terms of anticipating and betting on a Federal Reserve (Fed) pivot. The market desperately wants the Fed and Chair Jerome Powell to back off from their historic rate hike policy. However, persistently high inflation would not allow the Fed to stop rate increases over the past year — until very recently. The latest deceleration in many inflation readings gives the Fed and investors breathing room and a sigh of relief — “At Ease, soldier!”

The Goldman Sachs Financial Conditions Index (FCI) is the clearest expression of the massive ease in the market. The FCI is a weighted average of riskless interest rates, the exchange rate, equity valuations and credit spreads, with weights that correspond to the direct impact of each variable on gross domestic product. This index tracks the tightness or easiness of financial conditions across the U.S. economy. As the Fed tightened policy, especially in 2022, you can see higher spikes in the monthly (but not cumulative) readings. As the U.S. 10-year Treasury yield reached 5% in October, financial conditions tightened, sending a shiver throughout the stock and bond markets. However, as inflation readings improved and 10-year yields slipped back to 4.2%, this unleashed the greatest monthly reduction in the FCI in many decades.

Key Takeaway

Looking ahead, as the markets are doing now, the seemingly imminent Fed pivot is likely probable this time, unlike the two head fakes we experienced over the past 12 months. This rate cut expectation is starting to create a massive rotation into many downtrodden income sectors — banks, real estate investment trusts, investment-grade bonds (and high-yield bonds, of course, although they are not really downtrodden after leading many income universe sectors in 2023), stocks of levered companies and just about any interest-rate-sensitive security. Given the low valuations in many of these areas (for example, single-digit price-to-earnings (P/E) bank stocks), this could create a more persistent rally in value stocks and indices heading into 2024. While it is unlikely that the much-publicized performance and valuation gap between value and growth stocks will be closed, it certainly could narrow quite a bit as we saw over the past month. 

If you could tell us where rates go from here, we could probably tell you what happens next to the stock market.  If inflation has been tamed and rates have peaked and turn lower, this should continue to breathe life into income stocks through higher valuations (which does not tell us what will happen with earnings growth, but we’ll take it from a valuation perspective). Even after the November rally, many bank stocks trade with single-digit P/Es, which may allow for a nice bump up in the intermediate term with a simple change from 8x to 12x, for example. Levered companies with new management teams strategically willing to address their debt and cost structure issues could also see a more sustained benefit. For both groups of income-producing securities — dividend-paying stocks and corporate bonds — the market, in the short term, will not differentiate between the long-term sustainable names from the ones that are structurally flawed. That is our job as investors. The opportunity is there for potential turnarounds and P/E depressed names, as long as rates have truly peaked and growth does not decline from here.

In the meantime, interest rates are clearly in the driver’s seat for the markets — and they certainly have our undivided attention. It will be interesting to see where they lead us, but we will enjoy this time for now as the markets are breathing a little easier.

Tags: Interest rates | Markets | Federal Reserve | Investment strategy | Inflation | Treasury yields

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