Stocks retreated in the third quarter, driven lower by that bane of stock rallies, higher interest rates. Thankfully, the rise in interest rates was not accompanied by a rise in reported or expected inflation, as the Fed’s favorite Inflation measure, the core PCE or Personal Consumption Expenditure index, (which excludes volatile food and energy) has now had three improving months in a row. Yet, while short-term interest rates rose negligibly in the quarter, long term rates on the 10- year and 30-year Treasury notes and bonds rose 0.73% and 0.82% respectively. For the 10-year note now yielding 4.57%, it was the highest yield since October of 2007.
The recent sinking spell of stocks and long-term bonds began on July 31st, when the Treasury boosted its estimate for Federal borrowing to $1 Trillion in the current quarter, which was a big jump from the $733 billion it had estimated in early May, and what was expected by Wall Street. The increase was partly driven by the Treasury’s need to rebuild its cash balance from the level of near zero reached in early June during the last government shutdown. Also contributing was the Fed’s resumption of Quantitative Tightening as it lets approximately $95 billion in debt run off its balance sheet each month.
In the end, we are paying the price for the issuance of a tsunami of debt and spending beginning with the American Rescue Plan of March 2021, when $1.9 Trillion of new “emergency” spending and debt was facilitated by the Federal Reserve, which conveniently saddled its balance sheet with virtually the entire balance. This borrowing and spending occurred notwithstanding the fact that GDP in the prior quarter (4th quarter of 2020), was growing at a healthy 4.1% rate. Indeed, as Jeremy Siegel of the Wharton School points out in a recent Barron’s article, the Fed “produced an explosion in the money supply such as has not been witnessed in the last 150 years”, with the expansion continuing at double digit rates well after the Pandemic crisis had abated. Thus, $7 Trillion in new government spending that was financed by money printing, not by new taxes, could not fail to dramatically increase inflation.
Consumption and the job market cooled noticeably in August, as rising gasoline prices, the resumption of student loan payments, and the depletion of $2 trillion in savings accumulated during the pandemic combined to slow retail sales and hiring. In response to this moderation, last week the Fed left the Fed funds target range unchanged, although it did leave open the possibility of one more rate hike later this year.
As the debt markets appear to be anticipating “higher for longer” interest rates, it would appear that more generously valued growth stocks, such as “the Magnificent Seven” (Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia & Tesla) might face headwinds, as the rate at which future earnings are discounted, which is more important for such investments, will be higher, and the discounted value of future earnings will be lower. While we do not believe these equities are in an investment “bubble” like that experienced during the dot.com implosion of 2001-2002, we do think that valuations will become more important to investors going forward. This suggests investors should follow a balanced approach, investing in companies with higher expected growth, but also in more traditional stocks, which are becoming more attractive as valuations improve for the first time in years. Lastly, we maintain our recommendation to purchase fixed income investments, whose appeal continues to increase as interest rates have risen and inflation has declined. As the Greek philosopher Epicurus said, “Be moderate in order to taste the joys of life in abundance.”