At Wednesday’s rate setting meeting, the Federal Open Market committee (FOMC) kept the fed funds rate unchanged at 5.25-5.5% and reiterated that it will continue to assess the extent of additional policy firming based on the incoming economic data.1 This “hold” was largely telegraphed, as most Federal Reserve (Fed) officials coalesced around the idea that the recent tightening in financial conditions – led by the sharp rise in long-end rates – would not necessitate a further rate increase.2
During the subsequent press conference, Fed Chair Powell leaned dovish, suggesting that the effectiveness of the September dot-plot forecasts diminishes over time, potentially signaling less support for another rate increase down the line.3 Powell also acknowledged that the increase in rates is aiding the Fed in tightening financial conditions, though he did emphasize the need to assess its persistence.4
The other big event on Wednesday, and arguably the more important one, was the better-than-expected U.S. Treasury quarterly refunding announcement for the November 2023 to January 2024 quarter (Q4’23). The U.S. Treasury said it plans to sell $112 billion of securities, up $9 billion from the previous quarter, but slightly less than the $114 billion the market was expecting.5 Additionally, looking at the anticipated auctions sizes for various maturities, the key takeaway here is that most of the heavy lifting will be done at the front-end of the curve with the majority of it coming from two to seven year maturities. This should ease the upward pressure on long-end rates.6
A local top in long-term rates in the near-term sets up better risk/reward for equities into year-end
With these two developments in the rear-view mirror, it appears increasingly likely that we have reached a local top in interest rates and are now settling into a trading range. The appropriate path of central bank policy – a higher-for-longer Fed – has been priced-in, oil and forward inflation expectations have retraced lower from their respective October peaks, and the broader economy is expected to grow in the fourth quarter at a less robust clip.7 All of these factors align to support a pause or move lower in rates.
Indeed, the yield on the U.S. 10-year Treasury is currently trading well above (+31 basis points (bps)) the model-implied fair value, which takes into account factors like growth, inflation, and policy.8 And the divergence could have been previously explained by concerns about U.S. Treasury borrowing. However, the muted reaction in rates from Monday’s updated U.S. Treasury borrowing intentions and the decline in yields following Wednesday’s better-than-expected U.S. Treasury quarterly refunding announcement, suggest that these concerns are now much better digested by the market over the near-term.
With that in mind, we see scope for long-term yields to retrace lower or at least pause, and that could support equities into year-end. Indeed, with the crucial FOMC meeting and U.S. Treasury quarterly refunding announcements behind us, we see room for a relief rally as the setup looks cleaner into year-end and the risk/reward increasingly skews more positive. Specifically, strong seasonality, washed out positioning and sentiment, return of corporate buybacks, and solid earnings/economic growth could collectively provide support, assuming the local top in yields holds.
For context, since 1990, seasonality has been the strongest in November and December, with the S&P 500 higher 73% and 76% of the time, respectively, for an average monthly total return of +2.1% and +1.7%, respectively.9 Sentiment, as proxied by the American Association of Individual Investors (AAII) bull/bear spread, is now at its lowest level since May.10 The largest buyers in the market, corporates, are set to return to the market, with roughly 70% of S&P 500 companies expected to be in the open window by week’s end.11 This will start the best two-month period for buyback executions.12 On the economic front, consumers continue to spend, with high frequency data on credit card spending suggesting further increases in consumer spending in October (Exhibit 2).13 And finally, on the earnings front, roughly 50% of companies in the S&P 500 have now reported third quarter earnings, with 78% reporting a beat on earnings for a blended earnings growth rate of +2.7% for Q3 2023, well above the expected -0.3% decline at the start of the earnings season.14 Looking ahead, calendar year 2024 earnings estimates have been revised down slightly, from +12.2% year-over-year (YoY) to +11.9%, but at a slower rate than some analysts were expecting.15 Taken together, this suggest that if there is going to be an economic downturn, it is not happening quite yet, and at least not before year-end.
Longer-term, however, we see more reasons for investor caution in 2024
Beyond the year-end, the catalyst for a sustained bullish re-pricing into 2024 remains to be seen. We are becoming more concerned that 2023 was the soft-landing year and 2024 could become the hard-landing year, absent a more significant near-term pivot from the Fed, such as a pause in quantitative tightening (QT). Currently, the Fed is allowing up to $60 billion of its holdings to roll off its balance sheet each month which has forced the U.S. Treasury to issue more to the public.16
Investors should remember that QT is quantitative easing (QE) in reverse, meaning QT is unwinding what QE has done. This means that as QE increased the demand for longer-term U.S. Treasuries, thereby capping yields and lowering the term premium, it follows that QT should increase the term premium and yields at the long end of the curve. This in fact has been the case with the term premium on the U.S. 10-year Treasury now at 0.42%, a roughly 100bps increase since the start of August (Exhibit 3).17
At the same time, QE is no longer financing widening budget deficits at inexpensive rates. This remains a problem going into 2024, as roughly 20% of the outstanding marketable U.S. government debt is set to mature and will need to be rolled-over at higher rates (Exhibit 4).18 Again, absent a more significant near-term pivot from the Fed, interest expense on the government’s debt is expected to grow substantially over the coming year(s), which will give way to investor concern that long-term rates may remain high and act as a headwind to the market.19
The reality is that the longer rates stay elevated and the Fed remains restrictive, the more previously cheap debt will have to be rolled over across the economy at higher rates. This means that the corporate, commercial real estate, and household sectors, among others, are not immune to the same issues facing the U.S. government. However, for the corporate sector in particular, we remain less concerned about its ability to refinance given the lack of floating rate exposure and relatively benign wall of maturities.20
Still, the initial challenges of higher interest costs have already started to materialize in the economy through higher defaults, delinquencies, and charge-offs – all of which are up on the year (Exhibit 5).21 The number of bankruptcies among companies backed by private equity (PE)/venture capital (VC) is on the rise, bank charge-offs are rising, and both high yield and leveraged loan default rates are up.22 Importantly, while all of these remain at relatively contained levels and are coming off a low post-pandemic base, more is likely to come next year since more debt will need to be refinanced at high-for-longer rates. For instance, in 2024, the Fed funds rates is expected be at 5.1% compared to the 4.3% expectation from March 2023.23
That said, to go “all-in” on risk, we need to see a true pivot that acknowledges the risks from rising delinquencies and defaults. The risk is that further market downside/more defaults will have to occur first before the Fed ultimately pivots.
What should investors hold, buy, and avoid?
From a tactical perspective, we would favor trading Tech into a year-end rally, especially as Tech is one of the most “immune” sectors fundamentally from higher rates and oil headwinds.24 Additionally, although valuations and positioning in the sector have reset lower, earnings growth remains solid. The S&P 500 Info Tech sector, while still not dirt cheap, is currently trading at 24.1x forward earnings, down from 27.9x this summer and now in the 56th percentile over a 5-year lookback.25 And earnings growth in the sector is projected to be up 16.5% YoY for 2024, as cloud deceleration stabilizes and artificial intelligence (AI) adoption and monetization continues.26 We would add to Tech through structured investments, which continue to price attractively amidst the current rate and volatility backdrop.27
For long-term investors, we favor holding a portfolio of cash (money market funds), municipal bonds, investment grade (IG) corporate bonds, and private credit, which yields equity-like returns but offers better risk profiles. And within equities, we continue to prefer high quality/profitable Tech (especially Software), Energy as a potential hedge against inflation and geopolitical risk, and private equity as valuations on new deals continue to reset lower.28
Finally, knowing what to avoid is just as important as knowing what to buy or hold. We would avoid interest-rate sensitive parts of the economy with high percentage of floating rate liabilities and large maturities that need to be rolled over. Specifically, areas of the market we would avoid include the consumer discretionary sector, which remains at risk from the impact of high mortgage and credit card rates, leveraged loans with declining interest coverage ratios, U.S. Treasuries with unfavorable fiscal dynamics and significant maturities, and finally, select older vintages in the venture capital space which is burdened by previously inflated valuations and challenging conditions for unprofitable tech companies. In the coming weeks, we aim to further frame out what this elevated, but more stable rate environment means across various pockets of the economy and where opportunities and risks may lie.
1. Source: Federal Open Market Committee (FOMC), iCapital Investment Strategy, as of November 1, 2023.
2. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
3. Source: Federal Open Market Committee (FOMC), iCapital Investment Strategy, as of November 1, 2023.
4. Source: Federal Open Market Committee (FOMC), iCapital Investment Strategy, as of November 1, 2023.
5. Source: U.S. Department of the Treasury, iCapital Investment Strategy, as of November 1, 2023.
6. Source: U.S. Department of the Treasury, iCapital Investment Strategy, as of November 1, 2023.
7. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
8. Source: JPMorgan Research, as of October 31, 2023.
9. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
10. Source: American Association of Individual Investors (AAII), iCapital Investment Strategy, as of October 26, 2023.
11. Source: Goldman Sachs, as of October 30, 2023.
12. Source: Goldman Sachs, as of October 30, 2023.
13. Source: Bloomberg, JPMorgan, iCapital Investment Strategy, as of November 1, 2023.
14. Source: FactSet Earnings Insight, as of October 27, 2023.
15. Source: FactSet Earnings Insight, as of October 27, 2023.
16. Source: Bloomberg, Federal Reserve, iCapital Investment Strategy, as of November 1, 2023.
17. Source: Bloomberg Federal Reserve Bank of New York, iCapital Investment Strategy, as of November 1, 2023. Note: term premiums refer to the additional return required by investors for holding longer-term bonds. Term premiums are the difference between the return investors gain by holding bonds with extended terms and by investing in the short-term bonds for the same total amount of time.
18. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
19. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
20. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
21. Source: Bloomberg, Pitchbook, LCD, BofA Research, CapitalIQ, iCapital Investment Strategy, as of November 1, 2023.
22. Source: Bloomberg, Pitchbook, LCD, BofA Research, CapitalIQ, iCapital Investment Strategy, as of November 1, 2023.
23. Source: Bloomberg, Federal Reserve, iCapital Investment Strategy, as of November 1, 2023.
24. Source: iCapital Investment Strategy, as of November 1, 2023.
25. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023. Note: S&P 500 Information Technology Index is a capitalization-weighted index of information technology companies as defined by GICS Level 1 sector grouping.
26. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
27. Source: Bloomberg, iCapital Investment Strategy, as of November 1, 2023.
28. Source: Bloomberg, Pitchbook, iCapital Investment Strategy, as of November 1, 2023.
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