New Regime

By Ketu Desai

September 1981 is the month when rates peaked on the 10-year at 15.84 percent. For more than 40 years rates steadily declined to near zero. This bull market in rates brought a bull market in many asset classes that benefit from cheap financing including real estate, private equity, and venture capital. We are in a new regime for investors. The mistake that will be made in this cycle will be to overestimate monetary policy and underestimate fiscal.

The bond market is now working on its third consecutive down year. The 10-year has had a cumulative decline of 26 percent. Longer-duration bonds as measured by TLT have been cut in half. Despite multiple wars, geopolitical risk, and significant economic uncertainty, bonds have failed to protect portfolios. The Fed looks to have finally gotten its message across that rates will be higher for longer. The yield curve is just about un-inverted, going from over 100 bps inverted during the summer to just about flat. This is a reflection that the market is finally pricing at higher rates for longer. While the Fed is close to finishing raising rates, the long end will remain anchored higher by the economy, higher steady state inflation, and the fiscal situation.

As rates were moving lower, it was profitable for investors to invest in companies that were levered and benefited from cheap debt. Cheap financing allowed companies to grow and helped drive multiples higher. Now that rates are higher, we are moving from a debt/cheap financing cycle to an income cycle. In other words, investment should focus on companies that have earnings power, not ones that are growing because of and reliant on cheap financing. Earnings for the S&P appear to have bottomed out and are now on the way up. For the third quarter, 78 percent of companies are beating by an average of 7.5 percent. More importantly, 2024 earnings growth is expected to come in at 12 percent, led by communication services, technology, and healthcare – three of the largest sector weightings in the S&P. We have seen beats and strong guidance by some of the most important companies including, JP Morgan, UnitedHealth, Netflix, 3M, Verizon, GE, RTX, Coca-Cola, Hilton, Merck, Meta, ServiceNow, Honeywell, Amazon, Chipotle, AbbVie, Intel, and McDonald’s.

Income versus debt is also important for the economy. While the fiscal situation remains challenging, large corporates and the consumer remain in good shape. The consumer is approximately 70 percent of the US economy. The household balance sheet remains strong. Net worth is at the highest level ever, growing 37 percent since 2019. There is more than $4 trillion in household cash on the balance sheet. There is more than $1 trillion in excess savings. Household debt to GDP is the lowest since data going back to at least 2005. Similarly, household debt service to disposable income remains at historically low levels. Only 11 percent of outstanding household debt carries variable interest rates. Unemployment remains low and wages continue to grow.

As far as the market goes, it is easy to be negative. Much of that negativity is priced into the average stock. The Russell 2000 has been flat since August 2018, while earnings have grown 32 percent. The S&P 500 is down 10 percent over the past two years and at a level first reached 30 months ago, with U.S. GDP now 18 percent larger than it was then and annualized earnings 10 percent higher. Earnings have bottomed out and are expected to grow next year. The economy remains in good shape with GDP up 4.9 percent in the third quarter.

Inflation is moderating. PMIs looked to have also bottomed out and are likely to move up. The volatility in yields is likely to come down. The buyback window is now open and will continue into December. Positioning and sentiment remain poor. By certain measures, positioning among hedge funds is the lowest it’s been since 2019. We are entering a seasonally bullish time. There is approximately $5 trillion in money market assets that will eventually look for a new long-term home. The Fed is close to done with raising rates, while fiscal spending will continue putting a floor on nominal growth. Nominal growth drives earnings. Public markets offer some of the best companies with the best balance sheets in the world to capitalize.

In the coming months the market will focus on the Fed, geopolitics, the latest from Washington, economic data, and earnings.

Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com