Investment Insights

 — Steve Orr 

BTTF

Or perhaps we should title this week’s missive “What goes around comes around.” We will not belabor the point that the 40-year Bull market in interest rates is over. U.S. Treasury rates bottomed during the shutdowns of March 2020. By the end of 2021, the 10-year had risen to 1.5%, roughly its pre-shutdown level. Investors noted a negative return but were not perturbed. 2022’s more than doubling again to 3.8% did turn heads. Now longer-dated Treasuries had their first back-to-back losing years. College coaches get fired for less. 

Inflation and attractive rates on cash have lowered investor demand, pressuring prices. This year’s ballooning federal spending and less buying from central banks have boosted supply, further pushing down prices. Since Congress removed the debt ceiling four months ago, $2 trillion has been added to the federal debt. In that span, the 10-year Treasury has climbed nearly 1%, finishing last week at 4.79%. According to the Office of Management and Budget estimates, the national debt of $33.4 trillion exceeds our country’s gross domestic product by 30%. That is a level that historically cuts a nation’s potential growth by more than half. It makes one wonder how we can pay back our debt if we cannot even grow the economy at a reasonable (2.5% to 3%) rate. 

We focus on the 10-year Treasury note because mortgages and many corporate bonds use it as a pricing benchmark. The longer the maturity, the more interest payments, or coupons, to discount. Thirty-year bonds are much more sensitive to changes in rates. From those 2020 lows we mentioned earlier long Treasury prices are down 50%. What other asset class has that amount of drawdown? How about stocks in the dotcom bust of the late 1990s and 2008-09? Rate increases by the Fed and unchecked spending by Congress have caused enough price drop in long Treasury bonds the last three years to wipe out positive returns over the prior seven years. In other words, if you bought 30-year Treasuries a decade ago, you would have roughly a zero return. In fact, you would have lost purchasing power thanks to inflation. Most of us do not buy long-dated Treasuries, however. That would be folks smarter than the average bear, namely pension funds, life insurers and other institutions with long time horizons. We do not envy their situation — their balance sheets are carrying plenty of red ink. 

We do not believe we are headed back to the future of early 1980s double digit rates. Could continued inflation, buyers’ strikes and Congressional spending force long rates above 5%? Certainly. And if rates get high enough or crimp activity long enough, we will have a real recession and rates may come down a modest amount. 

What is different?

The Wall Street narrative this year: “Be patient, the Fed has to stop raising rates soon and start cutting.” The narrative theory is that when the Fed cuts short-term rates, then yields will fall and bonds will be happy again. We have repeatedly cautioned against this narrative. It did and does not fit the reality of Fed statements and the economy. Fed speakers have consistently said their only objective is a return to 2% inflation. Capitulating on 2% and raising their goal to 3% would restart the “Fed no credibility” argument. They have been less consistent regarding whether more rate increases are necessary. Dallas Fed President Logan and San Francisco President Daly have both stated recently that current conditions may lessen the need for further rate increases. That does not mean in any sense that the Fed is about to cut rates.

If the economy continues to lumber along in second gear, posting 1.5% to 2% real growth and inflation hovers around 3.5%, then current rate levels may persist for longer than markets expect. History says the Fed only cuts rates when they realize they have gone too far, and the economy is tanking. Do we see slowing in certain areas, especially manufacturing? Yes, but not enough to call an immediate recession and a turn lower in rates. 

Top line

Last Friday’s September jobs report requires some explanation. The 336,000 net new jobs reported by the BLS in the business survey was a big surprise. Like several standard deviations surprise. For the first time this year there were upward revisions to the prior two months. All this good news would lead you to believe the Fed needs to raise rates to cool the economy. We will get some idea of their thinking when the FOMC’s meeting minutes are released this Wednesday. Back to the numbers. 

Private sector payrolls jumped 263,000 month-over-month. This is above the trailing year average of 214,000 monthly increases. Another reason for the jump was the government sector, mostly due to returning teachers. This year government hiring is responsible for about 20% of all job gains. Note that October’s report will not be as strong, as we expect the UAW strikes (including Mack trucks) will last into next week’s survey period. 

Not so fast on the Fed raising rates with strong job growth. Down in the details, most job gains were in lower-paying fields. The household survey did not match the robust business survey. Asking people at home if they got a new job only resulted in 86,000 net new jobs. Bear in mind that the headline number includes full-time, part-time and temp workers. A good portion of recent growth is in the part-time category, as more workers hold down a second job. In fact, respondents saying they had a primary and a secondary job hit an all-time high. For full-time workers, the kind of jobs with health benefits has declined for three months straight and is back to February levels. Bottom line: Consumer spending is dependent on steady jobs and positive expectations about the future. Consumer sentiment and expectations are down from a year ago. Look for slowing growth ahead — your easiest news indicator would be slow holiday sales. 

Bounce house

“But wait” you say, last Friday stocks rallied over 1% after the jobs report. True enough, some traders bought on the news. We would suggest, that, given volume was just average, a big chunk of Friday’s gains was traders covering their short positions before the Monday bond market holiday. True stocks are open on Monday, but plenty of folks were out. Traders also liked the fact that the jobs number was not as strong as the headline suggested. Any thought that the economy may slow enough to get the Fed to cut rates is a positive, in their view. They also liked the slowing average hourly wage number, but that slowdown is likely due to the rising proportion of part-time jobs in the data. 

Fourth quarter stock rallies have a longer history than Pumpkin Spice popularity. Strong gains by stocks in the first half of the year generally mean good performance in the last three months. Are rates and stocks oversold and due for a bounce? Technically, yes. Nearly every sector and the headline S&P 500s are oversold. Advance-decline lines are negative and the percentage of stocks making new lows outstrip new highs by a 4 to 1 margin. The S&P 500 did bounce Friday off of its 200-day moving average, but one or two days does not change a trend. 

What would get the fourth quarter bounce house in gear? Positive earnings surprises (higher), inflation surprises (lower) and calming of overseas tensions. Earnings season gets underway this week. Third quarter reports from Pepsi, Walgreens and Delta lead off Tuesday and Wednesday. The big banks report Friday: JP Morgan, PNC, Wells and Citi. Over the next two weeks, 40% of the earnings reports will be from banks and financial companies. FactSet reports that as a group, financials should show earnings growth last quarter of about 8%. We wonder about reporting earnings on Friday the 13th. Traders will be watching closely, as concerns about deposits and deposit rates from March are still front of mind. 

That would put banks well ahead of the aggregate estimate for the S&P 500, which hovers around -0.3%. If the estimate holds, that would be the fourth straight quarter for earnings declines. Perhaps the recession is already here for company earnings. Referencing consumer sentiment above, we note that Levi Strauss recently cut their full-year sales outlook. Levi Strauss CEO Chip Bergh stated that they see “continued softness in the wholesale channel, primarily in the U.S.” If the retailers are not buying that means either fewer folks are hitting the stores, or they have inventory that is not moving. Same difference.

In addition to earnings reports ramping up, Producer prices will be released Wednesday and the Consumer Price Index on Thursday. Consensus is for 1.6% and 3.6%, respectively. The Michigan Consumer Confidence survey is released on Friday and is projected to show consumers expecting a recession in the coming months.