August was an interesting month in the US sovereign bond markets. The first half of the month was characterized by higher bond yields, with the US 10-year Treasury yields reaching its highest level since 2007. This was followed by yields moving lower through the back half of the month as several data points gave hope to investors looking for the Federal Reserve to stick its ‘soft-landing’ for the US economy.
Treasurys are known as a safe, relatively stable fixed income security offering near risk-free returns. These securities are critical as a benchmark for returns on stocks and bonds because investors will demand greater yields on other securities relative to these fixed income instruments.
The United States (U.S.) debt ceiling raise brought warnings of debt burdens and instability throughout the country. While it is impossible to know exactly why yields moved higher through the front half of the year, we can speculate about potential causes. At the beginning of August, Fitch Ratings downgraded the U.S. government’s credit rating from AAA to AA+ largely in response to larger deficits and repeated battles over the willingness of the US government to raise the debt ceiling and meet its obligations. This marked the first downgrade by a major ratings firm in more than a decade.
Regardless of the reason for the move higher, the implications are what matter most. In years past, return-seeking investors had few attractive alternatives to the equity markets. Today, investors are being compensated to own fixed income as many segments of the bond market are trading at yields comparable, and even superior to the earnings yield of the S&P 500.
So, what does the future hold for interest rates? Although the target inflation rate is 2%, the most recent data reported headline inflation at 3.2% and core inflation at 4.7%. With work to be done to meet the target, will the Fed raise rates at the September meeting? Market pricing would suggest not. However, Chairman Powell has suggested that interest rates could stay at elevated levels for a period of time in an effort to make sure that inflationary pressures do no resurface and force the Fed back into action.
Despite the Fed’s efforts to lower inflation by slowing the economy, the latest data continues to show that labor markets remain fairly resilient, and the US consumer continues to spend. However, we believe we are seeing cracks start to form. For instance, job openings continue to fall and are well off of their highs. While consumption growth has remained resilient, it’s clear that consumers are running down their savings to fund their spending. We don’t believe that this is sustainable.
Against this backdrop, major US equity indices moved modestly lower through the month. Nevertheless, there were some points of positivity. During the month, the S&P 500 hit its largest three-day gain since March, and the technology sector continued to show its strength. As yields fell through the back half of the month, equity markets moved higher.
We have been keeping a watchful eye on economic indicators as we wait for something to “break.” In other words, we would need to see slowing growth, credit tightening, or earnings pressure. Our expectation is that when these trends emerge, we will be in a recessionary period with a pattern of decline resulting in a shrinking economy.
As we have been communicating, our continued focus is risk management with a goal to protect against the threat of serious losses during down turning periods. With that plan in action, we have been focused on companies that are economically resilient, generating strong cash flows, and holding a competitive advantage in their industries.
3 Sectors We Are Watching
As the market fluctuates, we are building our shopping list to stay ready for any scenario. Get an update on the key themes unfolding in the tech, banking, and housing sectors and get our thoughts on the role these sectors will play in our portfolios as opportunities arise.
Read our views here: Tech, Banking, and Housing: What to Know
|Economic Cycle||The economy is late cycle. The Fed has hiked aggressively and while the economy has remained resilient to date, the manufacturing industry is showing serious pain and we anticipate that the lagged effect of monetary policy will start to be felt in other parts of the economy in the coming quarters.|
|Stock Market||The US stock market has rebounded strongly off its October 2022 lows. Sentiment now appears stretched and valuations are not compelling. To date, market returns have been driven by multiple expansion. EBIT margins climbed to historical highs in the years following covid lockdowns; elevated input costs and weakening demand and pricing power are posing a risk to the ability of corporations to maintain earnings at their projected level. Returns will be harder to come by and stock selection will be increasingly important.|
|Bond Market||Interest rates remain well off of their lows, as the economy has remained resilient and the market weighing the dynamics of still-elevated core inflation and the potential for interest rates to remain higher for longer. Corporate spreads remain well contained, particularly in light of the risks we see to the economy.|
|Important Issues on the Radar||Inflation: Factors including a resilient demand environment and wage increases threaten to keep core inflation elevated. Should this be the case, the Fed may remain tighter for longer.|
|China’s Economy: China has pivoted on the two key economic issues that acted as severe headwinds to growth over the last two years; however, economic growth appears to be stagnating and it will be critical to monitor the policy response in the coming months.|
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Source: Wall Street Journal
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