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Our Top Market Takeaways for August 18, 2023

Market update: Cruel Summer

It’s been a fever dream. Stocks took another step back this week as bond yields pushed higher. 10-year Treasury yields have now risen approximately 50 basis points in just the last month, outstripping the peaks we saw back in October and reaching their highest levels since 2007. And it’s not just the U.S. – the moves have been global:

This chart shows bond yields measured by the Bloomberg Global Aggregate Treasuries index from 2008 through 2023.

That begs the question: Why have bond yields been rising?

A lot of stuff can drive bond yield swings, but in the end, it can all be boiled down to three things:

  • Inflation
  • Growth
  • Uncertainty

The impact of each ebbs and flows over time.

We think the latter two are the biggest suspects, but let’s go through the line of the interrogation for each:

Suspect 1: Inflation

This was the story of 2022. As prices spiked (with headline Consumer Price Index (CPI) inflation reaching a zenith of 9.1% year-over-year that June), investors were forced to calibrate and re-calibrate just how much the Fed would have to hike to get inflation in check. With traders, businesses and consumers alike worried about prices continuing to rise, angst over the path of inflation drove much of last year’s moves.

Now, despite the round-trip in Treasury yields since last October, inflation doesn’t seem like the culprit this time. Sure, costs are still elevated, and some pockets like rising commodities prices may bring new pressure in the months ahead, but generally, the trend is still one of cooling. Shelter (think: rent) prices have accounted for about 80% of inflation over the past year, and leading indicators point to a big deceleration ahead (even if it happens gradually). Consumers also don’t seem all that worried anymore. Expectations for inflation over the next year and beyond continue to fall.

This chart shows U.S. consumers’ short (1 year) and medium (5 year) term inflation expectations in percentage points from January 2015 through July 2023.

Verdict: Not guilty.

Suspect 2: Growth

The recession that most have been betting on still hasn’t happened, with the U.S. economy defying the gravity of 525 basis points worth of Fed rate hikes. Most who want jobs still have them: the unemployment rate, at 3.5%, remains at historical lows. That’s meant that consumers are still eager to spend, even if the pace of that spending starts to cool and purchases get thriftier. The housing market seems to be stabilizing, and while manufacturing has been worse for wear since last year, some green shoots are starting to sprout.

There are also some signs that the U.S. economy could be getting more productive. Most tend to agree that the intense focus on artificial intelligence stands to change the way we live and work for the better, and a renewed focus on revitalizing infrastructure, bolstering supply chains and accelerating the energy transition could likewise safeguard against future threats to growth. But it’s all still a big question of just how much and when.

So, to some extent, investors seem to be accounting for better growth pastures, especially in the U.S. – but that’s also not necessarily new news. It’s been true for much of this year.

Verdict: Probably an accomplice.

Suspect 3: Uncertainty

We know that interest rates change over time. To account for that variability, investors tend to require more compensation for locking up their money for a longer time versus a shorter time. For bonds, that means demanding a higher yield for bonds that mature in, say, 10 years, than those that mature in two years.

The catch though, is that when things feel more “uncertain” than normal, some may demand an even higher yield for longer-dated bonds than they otherwise would. A number of developments seem to be adding some anxiety lately:

  • For one, Fitch’s recent U.S. government debt downgrade highlighted the known and long-term concerns over having a lot of debt…and repeated political squabbling over it.
  • That came at the same time that the U.S. government said it needed to issue more debt than it expected to in order to pay for all its spending, due to a combination of low tax revenues, high interest costs (from servicing that high stockpile of debt) and more fiscal stimulus. All else equal, more supply of Treasuries can put downward pressure on prices and upward pressure on yields.
  • Japan has been one of the lone central banks keeping monetary policy accommodative, while the rest of the world has tightened. But that’s starting to change: in recent months, the Bank of Japan has been loosening its grip on its yield curve control policy (which has kept policy rates in a tight band around 0%). Some are taking that as a sign that one of the last “anchors” for global interest rates is coming loose.

Verdict: Guilty.

In sum:

A combination of better growth and greater uncertainty seem to be behind the moves. On the former, a more resilient economy and higher odds for a “softish landing” could mean that the Fed will keep interest rates “higher for longer,” even if it’s pretty much done hiking. And on the latter, given that over the last month, 2-year Treasury yields have moved a fraction of what 10-year yields have (roughly 15 basis points versus about 50 basis points), it does seem like investors are asking for more (i.e., a higher yield) for the risk of holding longer-dated bonds.

But what does it mean?

With stocks taking a step back when bond yields are on the up, people seem to be questioning how much they’re willing to pay for riskier assets. One way to look at this is through the “equity risk premium,” which is essentially the pick-up in return that investors require for investing in stocks over bonds.

This chart shows the equity risk premium for the S&P 500 equity index in percentage points from 1990 through July 2023. The equity risk premium is calculated by the earnings yield of the S&P 500 minus the yield on the U.S. 10-year Treasury bond.

That equity risk premium has been declining over the last year and change, and that could mean a few different things:

  • On one hand, through higher bond yields, investors could be saying that bonds don’t feel as safe as they used to. That might mean that investors feel like they’re getting rewarded less for taking “more risk” with stocks than they did in past.
  • On the other, valuations for stocks today may be skewed by corporate profits in the midst of transition. S&P 500 earnings look like they just troughed in Q2, and while the recovery from here looks promising, it’s still in the process of materializing. To that end, stocks may just look “expensive” because they are starting to price in better growth ahead.

There are probably elements of truth to both camps, but we tend to skew toward the latter. That leads us to two investment conclusions:

1) We still think it’s time to be rebuilding equity portfolios. Many have been reticent to buy stocks so far this year, leaving a lot of investors with a lower allocation than they’ve had in years’ past. What’s more: not all of the market looks “expensive.” Stripping out big tech, the rest of the market is trading more in line with long-term averages. That offers a potential entry point into areas like industrials, mid cap stocks, and dividend-growth companies that could outperform, especially in a soft landing scenario.

This line chart shows the Information technology sector, the S&P 500 and the S&P ex-MMAANG’s next twelve-month price-to-earnings (P/E) ratio expectations, with data starting in 2013 and going to 2023.

2) Bonds look even better to us now…even if the Fed stays “higher for longer.” Higher yields mean bonds offer more income and more protection than they did just a month ago. The stocks vs. bonds debate also seems to be hitting a friction point: After stocks sank as bond yields hit a peak yesterday, all that worry in turn prompted bond yields to reverse course and drop into the close (boosting bond prices). While there may yet be spikes in yields, we still think the direction is eventually lower from here.

In all, we think investors should consider both. If bonds are pricing in a better growth outlook, we also think your equities will work for you. If we end up seeing a recession (or even just a growth slowdown), then your bonds can do the work to protect you. That’s all to say, it’s not a bad time to be a multi-asset class investor.

Your J.P. Morgan advisor is here to discuss what this means for you and your portfolio.

All market data from FactSet and Bloomberg Finance L.P., 8/18/23.


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