By Ketu Desai
In August of 1981, the 10YR Treasury hit 15 percent, and ever since we have had a bull market in bonds. That bull market now looks to be in serious question. This year will go down as one of the worst years in history for the bond market. TLT (20yr+ Treasury ETF) is down an amazing 35 percent this year, worse than most equity benchmarks. The “risk-free” portion of most people’s portfolio suddenly became one of the biggest sources of risk. The bull market in bonds brought a bull market in many assets that benefit from low rates and cheap financing including, certain growth stocks, venture capital, private equity, and real estate. It is quite possible that we are entering into a new regime of structurally higher rates, inflation, and nominal growth, driven by geopolitics, changes in supply-chain, change in labor dynamics, transition to clean energy, higher deficits, and quantitative tightening. Investors must rethink their asset allocation, as previously considered relationships may not be the same, as we have witnessed with bonds.
The Fed will raise rates another 75 bps at their November meeting, bringing Fed funds between 3.75 percent and 4 percent. It is likely we will get another 50 bps or 75 bps in December. Market-based measures suggest that the terminal rate will settle somewhere between 4.5 percent and 5 percent. The issue for the Fed is that they are attacking mostly a supply-based inflation problem by trying to reduce demand. This is not a long-term solution, increasing supply is a better solution. Bringing on more supply takes investment and often a long-time, especially as it relates to infrastructure and commodities. The irony is that the Fed keeps hiking, but higher rates raise the cost of financing making investment more difficult. While much of the inflation related to the pandemic will correct itself, we are facing a situation where investment needs to be made which will lead to structurally higher inflation and nominal growth.
Market internals might provide a glimpse into what the leadership will be in this new regime. While the S&P and the Nasdaq made new lows in recent weeks, small caps, energy, financials, industrials, and biotech have not. Most of these are up nicely since the June lows. The common thread of these sectors is that they are cheap and benefit from this new regime. Investment in key areas of infrastructure, national defense, supply chains, energy, commodities, and healthcare benefit these areas. Efficiency in many of these sectors will improve as the benefits of digitization and the cloud will accrue to the consumers of technology rather than the producers.
The near-term risk is a severe economic contraction. The data thus far has held up. Third quarter GDP came in at 2.6 percent. Earnings are coming in better than expected with 72 percent of companies beating, with strength in industrials growing 17.4 percent, consumer discretionary growing 19.9 percent, and energy growing 140.9 percent. Many are calling for a collapse in earnings, but it is important to remember that earnings are nominal. With 8 percent inflation this year, nominal growth will push double-digits. We could have negative real growth next year, but positive nominal growth. The dollar has been a headwind for US companies all year, this could turn into a tailwind for earnings next year. Unemployment remains low at 3.5 percent. According to Bank of America’s earnings’ presentation, consumer spending remains strong, delinquencies low, and consumer balances remain multiples above pre-pandemic levels. Consumers still have $1.7 trillion left in excess savings. If a recession is to come, the job market and the consumer will need to weaken. In the meantime, let the market internals guide your asset allocation, as relative outperformance leads to absolute performance.
Looking forward, the market will focus on the Fed, earnings, geopolitics and the latest economic data.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. [email protected]