Economic & Market Report: Forests Over Trees

October 20, 2023
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By: Nexa Financial Group

Global financial markets are shrouded in uncertainty, and the risks to the downside remain pronounced. Stocks continue to waver amid a difficult stretch dating back to the end of July. And bond yields continue to spike to levels last seen nearly two decades ago. While it is reasonable that investors may wish to recoil amid the swirling geopolitical and market risks, drawing back and taking in the views across the capital market landscape provides constructive reasons to stay the course.

Stock Reflections. While it is sometimes difficult to focus on the longer-term capital market forest when navigating the investing trees on a daily basis, it is remarkable to consider how far we have come over the last several years.

Remember the 2010s? Do you recall how monetary policy makers were stuck deep in a rut with the fed funds rate chronically stuck at the zero bound? And remember the Fed’s repeated compulsion to quickly intervene first with jawboning and then promises of easier monetary policy including another round of quantitative easing asset purchases anytime the U.S. stock market fell by more than -5% to -10% over a few weeks? This was the investment environment in which the financial world was trapped for years.

Every few years throughout the decade, Federal Reserve Chairs Ben Bernanke, Janet Yellen, or Jay Powell would start the conditioning process by first strenuously entertaining the idea of interest rate hikes, then creeping toward actually delivering them. We finally got our first quarter point hike in 2015 before quickly backing off. We then got eight more gradual and painstakingly telegraphed quarter point hikes over a two-year time period from December 2016 to December 2018 before the Fed backed down again once markets started freaking out with their worst December monthly return since 1931. Only a few months later, the Fed was back to cutting rates again to close out the decade. And then COVID happened, bringing us back to where we started at the zero bound.

So why such reminiscences on monetary policy? Imagine throughout this decade long time period the idea that the U.S. Federal Reserve would have to pull a complete transformation and instead of coddling the markets through the idea of a quarter point rate cut they would instead have to slam their foot through the monetary policy floor and jack interest rates by a whopping 5.25 percentage points in less than 18-months (while simultaneously shrinking their bloated balance sheet b.t.w.)? Presented with this scenario throughout the post Great Financial Crisis period, most investors would have reasonably presumed that U.S. stocks would be headed toward a major crash. As was feared for so long, the U.S. stock market simply wouldn’t be able to take having to stand on its own.

As it turns out, capital markets are a lot more resilient than believed for so long.  Sure, the S&P 500 descended into a bear market from January to October 2022 that saw the headline index decline by as much as -32% peak to trough, but this outcome likely had much more to do with the fact that the global economy was dealing with a scorching case of inflation.  But once it became clear by late 2022 that inflation was coming back under control thanks in good part to the strong interest rate response from the U.S. Federal Reserve, stocks swiftly staged a comeback.  In the year since, the S&P 500 has regained as much as 85% of the ground lost in the 2022 bear market along the way.  And this strong rebound has come despite the death of TINA (There Is No Alternative) for stocks, as both Treasuries and money market funds now offer attractive alternatives to owning stocks from a rate of return perspective.

In short, despite all of the challenges currently pressuring stock prices, it is worthwhile to consider how well U.S. stocks have held up over the last couple of years in what were previously unthinkable market conditions as recently as a couple of years ago.  Despite all of the threats, stocks are still within striking distance of new all-time highs.

Bond views.  Stocks are not the only major asset class that has seen their share of recent difficulties.  The largest outbreak of inflation since the 1970s sent bond yields soaring in 2022.  And following a brief respite in the first part of 2023, yields have since surged to new cycle highs.

While the 10-Year U.S. Treasury yield pushing north of 5% seems unimaginable but recent standards, it is important to put today’s rates into historical context.  While the move in Treasuries has been sharp over such a short period of time, the net result has been yields essentially reverting back to their 150-year long-term average at 4.5%.  Moreover, what was more of the outlier is the fact that Treasury yields were so low for such a prolonged period in the 2010s and early 2020s, not that they are as high as they are today.

Doesn’t this mean that Treasury yields could have much further to climb from here?  Not necessarily.  It should be noted that the long-term U.S. Treasury yield average was pulled meaningfully higher by the hyper-inflationary period from the late 1960s to early 1980s.  If one were to exclude this period and focus on the period from 1871 to 1967 prior to the inflation outbreak, the long-term average was only 3.6%.  As a result, unless we see a renewed and meaningful rise in inflation going forward, today’s Treasury yields are already running well above the long-term historical average in non-inflationary market environments.

Moreover, when examining the 10-Year U.S. Treasury yield in the context of its more than 40-year bull market channel where yields dropped from the mid-teens in the early 1980s to below 1% in recent years, we see that yields have spiked well above the top end of the range too far, too fast.  Even if the long-term bull market in bonds is over and yields remain higher going forward, some amount of mean reversion is long overdue at this stage.  This is particularly true as inflationary pressures continue to subside and particularly in the wake of oil prices pulling back sharply in recent weeks.

Bottom line.  While both stock and bond markets are providing a lot of risks for investors to consider and navigate, drawing back from the current data and taking a longer-term view informs us that stocks are holding up much better to date than might have been expected only a few years ago, while bonds are not only behaving much more normally than might otherwise be believed and are now long overdue for a bounce.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice.  All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.  Please consult a tax or legal professional for specific information and advice.

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