The Beat Goes On

This month, both the 2- and 10-year U.S. Treasury yields have risen, reflecting several interrelated developments. The 2-year Treasury, thought to be the most sensitive to the market view of the forward path of monetary policy, faced pressure throughout October as investors essentially ‘recalibrated’ — to use Fed Chair Powell’s word — expectations around how quickly the Fed would be cutting rates. Recall that the initial reaction to the 50-basis-point cut to the policy rate in mid-September was a lower 2-year yield as investors began to anticipate a relatively aggressive policy path of rate cuts going forward. Merely a month ago, the fed funds futures market placed a nearly 60% probability of a 50-basis-point rate cut in November. Conditions have changed notably since then. Markets are now pricing in a 90% chance of a 25-basis-point cut — a much more moderate pace, and one in line with the Fed’s (and our own) projections.

The strong labor market data reflected in the September nonfarm payroll report was the catalyst, suggesting that the economy is still chugging along with few signs of alarming weakness. Since then, the 2-year yield has risen to 4.07% — significantly higher than the October 1 level of 3.61%. During this period, longer-dated Treasury yields also rose. Again, this was largely a reaction to economic data and reflected a reset of expectations. Recall that prior to the Fed’s September meeting there were growing signs of potential weakness in the labor market, punctuated by an alarmingly weak August jobs report. Investors took that bad news and effectively ran with it, pricing in not only the more aggressive path of Fed rate cuts but also the possibility that the economy may not achieve a soft landing.

In short, the interest rate market, as reflected in longer-dated Treasury yields, got ahead of itself. But as subsequent economic data continued to surprise to the upside, investors began to reset their expectations, and this led to the rise in the 10-year Treasury yield. From the October 1 starting point of 3.74%, today’s yield of 4.21% represents a fairly sizeable increase over a relatively short period. It is worth noting that the rise in yield is partly attributable to the reset of expected growth, and it also reflects a rise in inflation expectations. Investors’ expectations for inflation — as reflected in the 10-year inflation breakeven rate — had fallen to 2% in mid-September. With better economic data, as well as some disappointing CPI data, this expectation also faced an upward adjustment. Today’s 10-year inflation breakeven rate is 2.3%.  

This week marked a break in the lengthy winning streak for U.S. stocks, with moderate weakness in the major averages. At the same time, market volatility as measured by the VIX — commonly referred to as the ‘fear and greed’ index — has remained elevated relative to the extremely low measures of early summer. We believe that the elevated volatility is likely a function of pre-election jitters — a pattern that is common ahead of U.S. presidential elections. It is probable in our view that volatility will remain elevated through the election. For equity investors, it is important to understand that better expected growth is the driver behind the rise in interest rates, which is a positive for risk assets. 

We do see higher rates impacting stocks in the small-cap universe. Smaller companies tend to rely more heavily on debt than those in the mega-cap S&P 500, and they typically borrow using floating-rate debt that makes their borrowing costs extremely sensitive to changes in interest rates. While the U.S. soft landing gives a nice tailwind to these companies in terms of revenue growth, the rise in borrowing costs offsets it in some ways. With the overall rise in interest rates over the past several years, many small-cap companies are already posting net losses, and roughly 40% are unprofitable.

There were many discussions this week about the future, including what the forward returns will be for the S&P 500. While hard to predict, we do have tools that we use to forecast future returns. Key inputs include the interest rate outlook and changes in expectations for revenue growth, profit margins and valuations. Commonly, price-to-earning (P/E) and price-to-cash flow (P/CF) ratios are used as valuation barometers. Will investors be willing to pay more for a dollar of earnings or cash flow in the future?

Interestingly, forecasting these valuation inputs can prove to be the most challenging. If we did this exercise 10 years ago, few would have anticipated that investors would be willing to pay today’s P/E of over 27 — a level well above historical averages. That said, we can look at long data sets, which tend to reflect those forward returns, to give a precedent. If valuations are below the historical average, it is likely that investors are requiring a higher risk premium for owning stocks and hence are expecting higher returns to compensate for the risk. When the starting point is elevated valuations — as they are today — forward returns are simply lower on average. Put another way, investors are currently pricing in an extremely low risk premium. 

We are in the midst of our annual forecasting exercise, and will publish our own outlook soon. It is too early to jump on the low-return bandwagon, but it is worth noting that, regardless of the outcome of this exercise, we anticipate our forecast will be another reminder to investors that sticking with a strategy and staying the course is always prudent, and even more so in a lower return environment. Missing out on the best days of the market can turn a lower return into a negative return.

Recent economic data in the U.S. continues to support a soft-landing narrative, with manufacturing and services PMI data surprising to the upside, durable goods orders falling less than expected and core durable goods (ex-defense and aircraft) rising month-over-month. Even consumer sentiment, as measured by the University of Michigan survey, rose above expectations, with the additional good news that 1-year inflation expectations were revised down to 2.7% from 2.9%. Further, weekly jobless claims were lower than expected, falling to the lowest level in a month, giving evidence that the labor market continues to show resilience. Will the strength of the data throw the Fed off course for November and December? We don’t think so. We continue to anticipate two 25-basis-point cuts in the remainder of 2024 and a total of four cuts in 2025, representing a steady pace of normalization.