The Last Mile 

“All endeavor calls for the ability to tramp the last mile, shape the last plan, endure the last hours toil.”

– Henry David Thoreau 

 The narrative driving markets entering 2024 was built on the assumption that the Federal Reserve (the Fed) had pulled off a near miracle by drastically reducing inflation back towards their 2% target without forcing the economy into recession. They were on the precipice of accomplishing the “immaculate disinflation” that most economists thought impossible to achieve. 

On the back of this miracle, markets expected the Fed to begin interest rate cuts in March and reduce rates up to six times in 2024. However, by February economic data was exposing cracks in this thesis, and doubts began to grow that a miracle had occurred. The rapid decline in inflation readings began to slow and have stagnated at levels that are still well above the Fed’s official target. Fed board members began to indicate they were prepared to hold rates higher than expected to keep inflation in check and that the future path of interest rates had become more uncertain. 

Equity markets shrugged off the changing macro-economic narrative and continued to climb in the quarter boosted by excitement around artificial intelligence (AI), strength in the US economy, and increasing earnings expectations. The US stock market remains priced for near perfection at a price to earnings ratio (P/E) of 20.7x which is difficult to justify in a sustained environment of elevated interest rates. In our last quarterly letter, we discussed the tension created by equity market valuations resting on expectations for both strong earnings and lower bond yields, outcomes that seemed to be at odds with one another. That tension remains even as the path on rates is far less accommodative than expected. 

Finishing the last mile in the struggle against inflation appears more difficult than expected and will require more diligent effort from the Fed. Markets seem to have more hours of toil ahead. 

Recent Market Activity 

US equity markets have continued to reach new highs this past quarter as earnings expectations have remained strong, the consumer has continued to spend, and the economy continues to grow. Growth sectors, driven by AI powered firms such as Nvidia and Microsoft, outperformed value sectors, but both indices posted strong gains in the first three months of the year. The gain on the S&P 500 was driven by both an increase in earnings expectations and multiple expansion as the forward P/E increased to 21.7 from 20.4. Given the changing interest rate expectations it seems that additional returns will have to be driven by earnings not a further increase in valuation. 

Other trends also persisted this quarter, as large capitalization US stocks continued to substantially outperform smaller domestic equities and international markets. The dollar strengthened during the quarter due to solid US economic growth and the expectation that yields in US money markets would remain elevated, providing an additional headwind to international returns. Even in local currency terms, US markets outperformed all large international markets except for Japan. 

Fixed income markets have experienced a disappointing start to 2024 as rising rates hurt the total return of high-quality bond indices. US Government debt, municipal bonds, and investment grade corporate bonds all posted negative returns, while riskier market segments such as high yield, convertibles, and leveraged loans produced positive returns since they began the year with higher yields and benefited from tightening spreads with safer bonds. 

Potentially significant rallies also occurred in several commodities markets due to strong economic growth and geopolitical concerns. Oil gained 15.7% while gold was up 6.5% in three months. The broader Goldman Sachs Commodity Index (GSCI) which includes energy, metals and agriculture products was up 10.1% indicating that commodity input prices are rising, a potential early indicator of stubborn inflation readings ahead. 

Tension Builds 

In the past few quarters, there had been a growing belief that the Fed would achieve the very difficult task of engineering a soft landing for the US economy. This would mean that inflation was tamed without causing a recession of forcing unemployment above 4%. This narrative is based on the Central Bank’s ability to reduce inflation to a point that rates could be cut prior to the full impact of higher debt costs stalling out economic growth. These rate cuts could then support steady corporate earnings growth and justify elevated equity valuations. 

Unfortunately, the data on economic growth, wages, and commodity prices indicate that the required steady decline in the rate of inflation will likely not materialize fast enough to get this delicate balance correct. Rates may have to stay at current levels for several more quarters and remain higher than anticipated throughout this business cycle. That reality is just now being absorbed by investors and will impact markets over the next few quarters as the magnitude of that adjustment is fully understood. 

The most recent economic data readings have given indications that a more troubling trend may be brewing: stagflation. Estimated GDP for the first quarter came in at 1.6%, well below expectations of 2.4% growth and near stall speed. While inflation continued to come in well above the Fed’s 2% target, little changed from the month before and continues to show that the trend toward lower inflation has plateaued. 

Stagflation is a term coined in the 1970’s that described an extended period of stagnant growth and elevated inflation. It is a difficult set of circumstances because the Central Bank and the Federal Government are unable to lower rates or increase spending to ignite growth due to the risk of sparking more inflation. It is a vicious cycle that lowers living standards and hurts almost all parts of a financial portfolio except for perhaps precious metals. 

We do not believe that a true stagflation spiral is likely and believe it to be a very remote left tail risk, but it is now a scenario that investors are starting to incorporate into their models and will likely cause fixed income yields to drift higher and make equity markets especially volatile as earnings reports and macro-economic data is released over the next few months. 

Stress Points 

The main risk of sustained higher rates is their impact on equity market valuation frameworks. The S&P 500, as a proxy for the US stock market as a whole, is priced for perfection, with a forward PE ratio of 21.7. This elevated measure is only reasonable if earnings growth remains strong and interest rates decline. Another way to get a sense for how stretched equity markets may be is to compare the earnings yield, or inverse of the P/E ratio, to treasury bond yields. Stocks are riskier than government bonds and thus should trade at a spread over current treasury yields, this is also sometimes referred to as the equity risk premium, or the amount of additional return investors require to invest in stocks over bonds. Please note that these are relatively crude measures but are helpful in getting a sense of how markets are positioned. 

At the end of March, the earnings yield on the S&P 500 was 4.61% (1 divided by 21.7) compared to a ten-year treasury yield of 4.20%. In April, yields rose to 4.6%, essentially equal to the earnings yield on the equity market. This implies that the stock market is very richly valued and shows how investors entered the year counting on cuts by the Fed to bring yields down and justify valuations. Now that yields are likely to remain higher than expected, valuations, and markets, may come under pressure.