The Revenge of Normal
“We have normality. I repeat we have normality. Anything you still can’t cope with is therefore your own problem.”
– Trillian, character from Hitchhiker’s Guide to the Galaxy
Robust returns to risky assets in the first half of the year were driven by 1) excitement around AI in a concentrated group of mega-cap technology stocks, 2) investor expectations that a weakening economy would force the Federal Reserve (the Fed) to start cutting rates this year, and 3) expectations that China’s reopening would support a surge in global growth. Unfortunately, those tailwinds became headwinds in the third quarter.
The environment of extremely low interest rates and limited inflation of the past 15 years was highly unusual, but the duration of this environment led to the normalization of investor expectations to a zero percent Federal Funds rate and bonds with negative yields despite the fact that these conditions were unprecedented in the longer-term historical context. Investors are adjusting to the reality that the future market environment may be significantly different than the past 15 years since the financial crisis in 2008, and asset prices are starting to reflect expectations of higher rates, stickier inflation, and increased volatility.
A market environment which more closely resembles longer-term historical precedent is not something to fear, but the road to get there will be bumpy. The first leg of the adjustment occurred in 2022 when stocks and bonds both sold off as short-term interest rates gapped higher. The second leg of the process has continued this year as fixed income markets adjust to higher long-term rates and equity investors gauge the impact on earnings. The final leg will likely occur over the next twelve months as long-term rates plateau, less liquid assets such as real estate re-price, and equity markets continue to focus on corporate earnings potential in the new normal.
Recent Market Returns
The third quarter marked a sharp reversal for financial markets as broad equity and fixed income indices all produced negative returns. A rise in yields drove the losses as the ten-year treasury went from 3.8% to almost 4.6% in three months and was indicative of a general increase in expectations for interest rates to be higher for longer. We entered the summer with markets expecting a Fed rate cut as early as the fourth quarter of this year and exited it with many strategists anticipating a Fed Funds rate north of 5% well into 2024.
The third quarter correction was broad based. All sectors of the equity market (growth, value, small cap, and international) and the aggregate fixed income index all posted negative returns. From an industry sector perspective, the energy sector rallied with a +12.2% return and communication services posted a 3.1% gain. All other sectors, including the technology, posted negative results.
Within fixed income, the losses were driven by the rise in rates and its impact on longer duration investment grade bonds. The US high yield and leveraged loan markets, populated by issuers that are below investment grade, have performed well this year and have both produced positive returns. This implies that investors are currently less concerned with the ability of companies to service their debt, but more concerned with managing the duration in their portfolios and adapting to the near-term path of interest rates. The safest bonds, US Treasuries, and high-quality municipals have performed worse this year than bonds of lower credit quality.
It is important to note that the increase in longer term yields has been caused by stronger than anticipated economic growth and a healthy labor market in the US. Corporate earnings have been widely resilient, and expectations for next year have started to increase. If the US is able to continue to grow, earnings will remain solid, the labor market will remain strong, and the Fed will not be forced to cut rates due to a recession or financial market crisis. In an odd market paradigm, recent positive economic news has led to negative returns. A more resilient economy is a positive development for markets in the long term, but, as investors continue to modify their rate expectations, we would expect to see more corrections like this quarter.
What is Normal?
We have been in a low-rate environment for so long that it is difficult to recall what the phrase “normal financial conditions” means in practical terms. Before discussing what normalized financial conditions may look like, it is important to review the fundamental importance of the Federal Funds rate and longer-term US Treasury rates in our markets.
The Federal Funds rate establishes the current cost of money in the financial system and helps provide an anchor to price all other assets in the economy. It is by definition a short-term rate, so it may not have a precise relationship with assets that have longer maturities, but it still informs how those assets price. The remainder of the US Treasury curve, especially out to ten years, has a more immediate impact on asset prices and valuations, but the base of this curve is the Federal Funds rate. Everything from home mortgage rates to the price to earnings ratio (P/E) of the stock market is influenced by the Fed Funds rate and corresponding Treasury yields, thus a reset of those rates permanently higher will have an impact on returns across all asset classes. All else being equal, higher rates mean future cash flows are worth less today because they are discounted by a larger denominator.
Another factor to consider is the growth in government debt and bond issuance at the same time that the Fed is reducing its balance sheet and embarking on a quantitative tightening program. During the pandemic, the US issued a tremendous amount of debt to support unprecedented stimulus programs to help the economy. The Fed lowered interest rates to near zero but also became the largest buyer of treasury bonds. It purchased a set number of treasuries every month regardless of the price, to support abnormally low long-term rates. Now that the Fed is out of the market, other buyers driven by a profit motive must fill the gap. This supply and demand imbalance has placed additional upward pressure on longer maturity bonds.
Investors tend to focus on the recent past, and markets have become conditioned to expect the extremely low interest rates we have seen since the GFC. However, if we expand our lens and look back at the last forty years, we get a better perspective on what short and long-term rates may look like in the future. While the federal funds rate has spent most of the last 15 years near zero, the long run average is above 3.6%. The ten-year Treasury has yielded less than 4% since the GFC, but its average since 1983 is above 5%. The US Central Bank is estimating that their Fed Funds rate will be 3.8% in 2025 while the swap market implies 3.7% two years from now. Strategists polled by Bloomberg expect the 10-year Treasury to be yielding more than 4% in that time frame. It seems that investors are embracing a return to a world where the overnight rate is approximately 3% and longer-term bond yields are closer to 5%. While this represents a return to a “normal” interest rate backdrop, it is a very different environment than the one we have enjoyed since 2008.
Beyond interest rates, there are other significant shifts impacting market conditions. Since the Paul Volker Fed tamed inflation in the early 1980’s, we have enjoyed a generally benign monetary policy environment supported by some key macro-economic factors that helped financial markets thrive. These factors included the following:
- Reduced regulation and more open markets starting in the US and UK in the early 1980’s and spreading to Europe and the former Soviet bloc by the early 1990’s.
- Increased globalization that lowered the cost of manufactured goods and decreased friction in global trade. This enabled the widespread use of “just-in-time” global supply chains that allowed firms to operate efficiently with limited inventory.
- Reduced labor costs as Asian nations, especially China, were integrated into global markets. This had the knock-on effect of reducing organized labor power in the US and limiting the average pace of wage growth in developed economies.
- The oil embargoes and price spikes in the 1970’s spurred producers to explore for additional energy resources resulting in major discoveries in places such as Alaska, the North Sea, the Gulf of Mexico, and offshore Brazil. Technology advancements eventually lead to the shale revolution in the US, unlocking additional oil and gas reserves. These combined efforts led to relatively stable and affordable energy prices.
These macro-factors reduced inflation, supported accommodative monetary policies, and lowered government bond yields. However, today all of these trends are reversing: government regulation and efforts to manage the economy are increasing; restrictions on trade are growing; firms are holding more inventory and focused more on resiliency than efficiency in their supply chains; China’s working age population has peaked; union power is growing in the US; and the effort to decarbonize our energy supply system will require substantial investment and increased costs over the medium term.
This turn in macro conditions could cause a more stubborn inflationary environment. Inflation has fallen from over 8% to 3.7% since the Fed began raising rates but getting the rate back to 2% will be a challenge. Both Fed and private sector strategists are forecasting core PCE, the central bank’s preferred inflation figure, to run above 2.3% in 2025. Economists see inflation well above the Fed’s target for at least the next two years. While no one expects a hyper-inflationary environment by any means, these forecasts present yet another indicator that “back to normal” may be a shock for investors accustomed to low rates and lower inflation.
Positioning for Normal
As we move through this adjustment period, we continue to favor the approach we discussed in our second quarter letter:
- Maintain a cash buffer to meet distribution needs for the next eighteen months. For portfolios that do not require current distributions, we are targeting a 5% holding in cash equivalents, which are earning an attractive yield and will serve as a ready source of liquidity if an opportunity to rebalance into equities, fixed income, or alternative assets presents itself.
- Within equities, we favor 1) the United States over international markets and 2) balancing growth and value exposures. Given the outperformance of growth stocks year-to-date, now is a good time to add to value strategies and maintain balance between these broad equity categories.
- We are monitoring additional opportunities in private credit. Stress in the banking system and a need for corporations and real estate owners to manage their capital structures will present opportunities for flexible private credit providers. These strategies may include direct lending, distressed assets, bridge financing, or structured credit and should be available over the next few years as the impact of higher interest rates flows through credit markets.
Our views on cash, equities, and fixed income are likely to evolve as yields start to peak in the next few quarters. Shifting cash into fixed income to lock in higher yields will at some point be an attractive shift. Within equities, moving out of the US and using the strong dollar to purchase cheaper international shares is another opportunity that may be an attractive exposure in portfolios. In general, being overweight US equities and underweight bonds has been the best way to profit from economic conditions over the last fifteen years. As the environment settles into a “new normal”, rebalancing portfolios towards target weights in fixed income, international stocks, and alternatives is a likely path forward.
“Normal” Speed Ahead
A return to markets that require an appropriate cost of capital is not something to be feared, it should be welcomed with enthusiasm. Investors are entering a period where safer instruments such as high-quality bonds can provide reasonable income and a measure of cushion for riskier equities and private assets. Fads such as cryptocurrencies, non-fungible tokens, and meme stocks will find it harder to catch on when money isn’t free, and the Fed will have room to reduce rates without resorting to purchasing bonds and implementing quantitative easing when we hit our next recession. The path to normal will remain volatile, but US financial markets have responded to new expectations and seem to have completed much of their adjustment.
We hope you are enjoying a wonderful Fall and look forward to visiting soon. Please contact us with any thoughts or questions.
President & Chief Investment Officer
VP, Head of Private Markets
VP, Head of Public Markets