Updated: Sep 11
The Process of Comprehending "Higher for Longer" ("H4L") Continues
The financial media's favorite narratives for 2023 have given way to the impossibility of making predictions. It has been observed elsewhere* that predictions are difficult to make, especially about the future. The Latin word from which our word "prediction" derives tells us quite a bit about the nature of predictions themselves. We receive the word to mean "to say beforehand", but classically its meaning is more accurately rendered as "prior agreed", or "premised", and lacks the sense that one's Fate is known (as in divinare, praenuntiare or ominari.) This knowledge is typically the province of the Gods; even when mortals learn what doom will befall them, they either ignore the advice or attempt--always unsuccessfully--to alter it. Knowing the will of the Gods is almost always a curse.
Our all-too-human predictions should be understood to be merely "prior opinions": based in our received knowledge about the past, the commonly accepted place we stand in the present, and our hopes and wants for the future. They are, therefore, merely stories we tell ourselves about ourselves, but that happen in the future. They are as reliable as the stories we tell ourselves about ourselves in the past--which is to say not very reliable. Every memory we recall is immediately altered by the very act of recall. Our memory of the future is similarly writ in water.
So it is time to abandon prior opinions, as they hamper our ability to determine where we currently stand. Given the collective experience of the 1970's and its outsized impact on the American psyche, it seems that the bout of high inflation following the end of the COVID-19 pandemic's disruption of ordinary life convinced most people that a return of long gas-, unemployment-, and bread-lines was nigh. Were there more people in positions of authority who had lived through the price inflations following the end of the first World War and the 1918 flu epidemic, or those following the end of the second World War, perhaps there would have been voices to oppose this view. Regardless, growth has not stagnated and high inflation has not persisted as they did following the supply shocks and fiscal profligacy of the 1970's. US Real GDP growth continues (2.1% in Q2), albeit more modestly than in the direct wake of the global reopening.
2.1% real growth still exceeds average trend growth over the past two business cycles, and is robust by recent standards. The Federal Reserve Bank of New York estimates current GDP growth of 1.6%--in the general range of what would be considered average for an economic expansion.
Over at the Atlanta Fed, the GDP Now forecast of future growth, which is based on the direction and level of several current indicators, suggests third quarter real growth of near 6%. There's often significant measurement error in this forecast, so it is direction, rather than level, that is important to note here: robustly positive.
The Federal Reserve's favorite measure of inflation, the Personal Consumption Expenditures (PCE) index, showed modest growth of 3.3%, a slight increase over the prior month, and a relief compared to the prior year's giant leap. When you drill down into the data, personal consumption was strong, and it is this consumption that drives the US Economy, accounting for nearly 70% of economic activity. While this is welcome news for the economy, one wrinkle does appear in the data: spending exceeded income, resulting in a decline in savings. It has been American's savings that has allowed households to continue to spend, and thus for the economy to avoid recession.
Much of the relief that consumers have been feeling with regard to prices has been for volatile food and energy prices. These have an outsized psychological impact because they are necessities and are bought frequently: they are the prices where consumer rubber meets economic road. At some point improvement in inflation will have to come from the decline in other prices. PCE excluding Food and Energy prices is uncomfortable at 4.2%. The Fed's job isn't yet done.
Removing outliers more generally from the PCE index yields a similar picture, which makes sense because Food and Energy prices are currently the outliers. The Trimmed Mean PCE of 4.1%, another alternative measure of core inflation, demonstrates this.
As we've written before, the cost of shelter is high and rising in America, both to buy and to rent. 30% of the CPI as measured in the United States consists of Owner's Equivalent Rent, which is the approximate rent a homeowner would pay to rent a property equivalent to the one that they live in. This is a controversial inclusion because, while it adjusts for the opportunity cost of using instead of letting out an asset (living in the house instead of renting it out to someone else), the cost is invisible or obscured to the owner, since they don't write themselves a check for rent each month.** When we strip this Owner's Equivalent Rent effect out of the inflation measures, price changes (1.67%) look positively quiescent.
Just to round out the discussion, below we show that, whatever progress has been made in bringing down the cost of goods, the rising cost of shelter (6.2%) and--to be shown later--wages, are the primary threads running through our inflation saga.
Payrolls expanded in July, with 187,000 workers added to employers' lists. These have been declining over the past three months, and saw revisions on the year (300,000 less than initially estimated). The market for labor continues to transact.
The Labor Force also expanded, with workers entering the market. The size of the US Labor Force has been in steady decline since the mid 2000s, a decline that accelerated in the aftermath of the Global Financial Crisis. After a mildly positive interlude, this number collapsed during the Global Pandemic but has continued to recover since then. In the long term the size of the Labor Force spells slower growth in the United States, just as it does for other developed economies and China.
As a consequence of potential workers re-entering the Labor Force, the Unemployment Rate shifted a bit, climbing .2% from 3.4% to 3.6%. The Unemployment Rate is still below the estimated Natural Rate of Unemployment (u*), the rate of unemployment at which the Labor Market is in equilibrium between supply and demand, and consequently isn't producing excess inflation. Estimates for u* vary but are generally believed to be around 4.5 - 5%.
An Unemployment Rate lower than the Natural Rate of Unemployment would indicate an imbalance between labor supply and labor demand, which should exert excess upward pressure on the price at which the market clears. The rising price of labor--the Wage Rate, as measured by Average Hourly Earnings--continues to increase at a rate higher than the general inflation rate. Average Hourly Earnings increased by 4.3%, a pace above the average since the Global Financial Crisis, and aren't showing signs of real moderation.
Another way to analyze supply and demand in the Labor Market is to compare the number of jobs available for every available worker. The resulting ratio provides a useful index of Labor Market tightness or looseness: a value greater than one signifies tightness; less, looseness. Tightness spells increasing wages, whereas looseness results in stagnation (wages are sticky to the downside.)
US corporations saw profitability contract in the third and fourth quarters of 2022, and in the first and second quarters of 2023. Add higher labor input costs to other rising costs and falling sales and you have the basis of a pullback in risky asset valuation. That said, higher wages encourage higher consumption, leading to more sales and higher growth. In fact, Corporate Profitability and Labor Compensation correlate over longer periods, as both are derivatives of economic growth in general; in the short term, their relationship can be more oppositional. In the big picture, and contrary to one currently prevalent narrative, it is not a zero-sum game.
Early indications from the Bureau of Economic Analysis for the third quarter are that corporations have to returned to profitability as their costs have stabilized and pricing power has endured. Perhaps most importantly for Americans' service-based economy, the Institute for Supply Management's Purchasing Managers' Index (PMI) increased markedly, pointing to substantial economic activity. Business activity (57.3 up from 57.1), new orders (57.5 up from 55), employment (54.7 up from 50.7) and inventories (57.7 up from 50.4) also accelerated, while business confidence increased. Although consumer confidence contracted a bit, these signals point toward continued expansion rather than the contraction that was broadly anticipated for the last two quarters of 2023.
Looking out from today, S&P 500 index level growth over the next year is priced to be an increase of 7.8%. That's in line with the annual average increase in the value of US equities, so doesn't in and of itself raise any eyebrows. However, the forward price-to-earnings (P/E) ratio for the S&P 500 index of large capitalization stocks stands at 20.05, meaning that investors in the aggregate are willing to pay $20 dollars today for $1 of earnings over the next year (and every year's earnings afterward, into perpetuity). That's a pretty high multiple to pay, even given the increased growth prospects in the near term, and what is likely a higher secular growth rate given the anticipated productive impact of the use of AI in knowledge work. Inverting the P/E ratio, we obtain what we believe to be a superior valuation metric, the earnings yield: 5%.
The alternative to buying the risky asset, as Capital Market Pricing Theory tells us, is to buy the risk-free asset, commonly understood to be the 10 Year Treasury. Bonds are yield assets, so equity earnings yields are directly comparable. The yield on the US 10 Year current stands at 4.27%, so the equity risk premium--the amount that investors are paid for assuming the uncertainty of investing in the equity market--is .72%. Even the most conservative estimates of what the equity risk premium should be--between four and five percent on the lower end--are about six times current pricing. The question these levels posit, then, is whether equities are 1/6th as risky as they historically have been, or whether the risk of investing in government bonds has increased sixfold. Only one of three conclusions are possible: either equities are too rich, bonds too poor, or some continuum between the two.
Put another way, a helpful, but somewhat unreliable man stops an investor during her Sunday walk in the park and helpfully draws her attention to a sum of money on the ground between them, and a separate, similar sum he saw someone tuck under a rock the day before. Would the investor rather pick up the $4.25 lying at her feet, or seek the $5 that might be under that remote stone?
Using advanced mathematics***, and given current market prices as inputs, we estimate that the return to US equities to be .72%, completely coincidentally equal to the Equity Risk Premium. That's if nothing changes over the next year--which it is certain not to be the case.
More ink than blood has been spilled in comparing the 2000's tech bubble to the frothy tech market of the past two years. History-minded investors have noted the similarities between both the valuations and the business models of companies involved in the two episodes. We find those comparisons apt, and would suggest another.
The popping of the internet bubble in the 2000's has been the focus of the narrative ever since the demise of Pets.com, as that's where the greatest excesses of financial Capitalism were on exhibit. What tends to go unmentioned is the role that Central Bank-supplied liquidity played in the runup to the bubble and its subsequent deflation. In anticipation of potential economic disruptions related to the Y2K Bug, the Federal Reserve increased the liquidity it supplied to the financial system. Once the new millennium arrived and the world continued to spin upon its axis, the Fed removed this provisional liquidity.
The NASDAQ proceeded to collapse over the following year as everyone knows, and that was the end of the Dot Com Bubble. Shortly thereafter, Web 2.0 began, and all the excesses of financial Capitalism were forever resolved, and a new, data-informed investment discipline took hold among analysts and bankers that prevented irrational exuberance from capturing the human imagination ever again.
Except that the story really shouldn't end there. Investors who lived through the era for a time referred to this period as the "TeleTech-TeleComs Bubble", an intimation of how our narratives about our past fail to capture the full story of that past. While Internet Tech stocks were crushed, Telecommunications stocks--the picks-and-shovels stocks of the Dot Com Bubble--maintained lofty valuations due to a witch's brew of residual hope, optimism, and financial shenanigans. These highly levered firms were unable to service their debt, corporate bankruptcies and restructurings proliferated, and the NASDAQ took another leg down, only finding its trough in October of 2002, a full three years after the Fed's liquidity provision.
2022 saw the bursting of another bubble in Tech stocks that has since been partially reflated as exuberance surrounding Generative AI and the chip companies that enable it provided another opportunity for the Eternal Hype Machine that is the financial media to exercise its lungs. Liquidity that had originally withdrawn from the markets by the Fed's restrictive policy (part of its inflation response) and the winding down of its vast debt holdings (the consequence of its response to the Global Pandemic) returned as the Fed responded to the failure of Silicon Valley Bank and First Republic, two banks whose fate was intimately interwoven with that of the new Technology Economy. As evidenced by reduced bank lending, liquidity is once again withdrawing from the economy, and yet one more leg that high equity valuations have stood upon has grown shorter. Whether AI companies and the chip companies that enable them will experience a drawdown in their valuations is unknowable, of course, but we remain fascinated by the similarities between these companies and the Telecom companies that preceded them.
We're not in the predictions business. No one knows what the future will hold. That's why we advocate for diversification in our investors' portfolios and are willing to miss out on the occasional asset price rallies we can't justify or don't understand. The current reflation of the equity market is one of those on the shores of which we are comfortable to stand in observation--with a judiciously-weighted toe in the water.
US Fixed Income
Besides the continuing disjunction between fundamentals and equity pricing, we look at the bond market and see less silliness. For quite some time the market had been pricing in a return to a low interest rate regime as early as the end of 2023, meaning that the collective opinion of the world's investors was that the Fed would take its foot off the brake**** and begin lowering interest rates in response to an anticipated recession. Now that the quarter in which the recession was supposed to take place is nearly over, and growth remains positive, the market has changed its mind and sees interest rates exceeding 4% for the next thirty years.
While the interest rate curve remains highly inverted, and this is typically indicative that a recession is imminent, an anticipated Federal reserve-engineered loosening is now being pushed out a year, after which a full point drop in interest rates is expected. Partly these higher yields are due to the higher rate of interest that the government has to offer to induce investors to accept the risk of default, or of delayed or partial repayment in the underwriting of its debt; partly they are due to the sheer volume of debt that is being underwritten at this particular point in time.
We do not doubt that the US Government will find a way to pay its bills.***** Nonetheless, as the benchmark rate above which all other risky debt issues are priced, these higher yields pose challenges for corporations that face the prospect of rolling their debt over the next two years. $2 Trillion in corporate borrowings are set of mature over the next two years, and given the prospect that inflation will remain elevated enough that the Federal Reserve must leave interest rates in restrictive territory, corporations will be issuing debt at much higher rates than those to which they have become accustomed in the post-Global Financial Crisis era. Higher borrowing costs mean lower profits, lower valuations, and more restructurings.
Currently, the difference between the yield on the average corporate bond issue and comparable treasury bond is 1.23%. This spread, like the Equity Risk Premium, represents the risk premium the market believes is appropriate to compensate investors for accepting the risks corporate bonds entail.
In the runup to the 2000 Dot Com bubble, spreads on Corporate Debt above the Treasury spot rate were comparable to those we see today. As you can see from the chart above, these spreads skyrocket during periods of stress. For example, they approached 3% in the aftermath of the Telecom Bubble; in the darkest hours of the financial markets, they can approach four or even seven points above the benchmark.
While we do not expect spreads to approach crisis levels over the next three years, we've been wrong before. We've been waiting for equity valuations to decline since the beginning of the year, and think they still have depths to plumb. Similarly, we expect that corporate bond yields will have to increase to compensate investors for the risks of lending to them. As the renowned economist Rudiger Dornbusch observed, 'In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.' September and October are often terrible months for the markets. It will be interesting to see how long it takes for the market to catch up with fundamentals, or whether it will at all. Whatever fate befalls, we are glad to be your company for the road ahead.
*The provenance of original quotations is amazingly difficult to establish. I am sure I will hear from many Lawrence Berra, Neils Bohr and Karl Kristian Steincke fans to the contrary.
**Perhaps they should?
***Known in the field as 'Addition', 'Subtraction', 'Multiplication' and 'Division'.
****An increasingly quaint idiom in the age of one-pedal driving.
*****There is a distinct advantage to your liabilities being denominated in your own currency.