November 03 2023

The Overrated Rate Relief

Despite the post-summer retreat, the first 10 months of the year delivered strong performance for large cap stocks (thanks AI boom!), while exposing fragilities for rate-sensitive instruments and sectors.

The main market change was, and remains, higher rates. By calling the end of a 15-year period of “cheap” money, it is resetting the stage for investors in a big way.

First, as rates reset higher, default rates will keep increasing in subprime credit for companies and households alike. The tail risk will come to whack the dog, all the more than subprime borrowers have multiplied during the decade and half of easy money. Areas to watch are leveraged loans, auto loans, and consumer credit.

Second, fixed income looks attractive again. The famous “bonds are back” slogan, which had been peddled a little too soon in 2023, regains its luster. As Howard Marks puts it in its “Full return world” podcast, “What’s the mistake today? Not taking advantage of these rates”. As a case in point, Stan Druckenmiller, an investor commanding a $3BN family office, took a leveraged bet on US 2y treasuries.

Third, 60/40 portfolios become relevant again, after being beaten up badly when bonds and equity all correlated to the downside in 2022.

Fourth, and this is of course controversial, volatility is back. Active managers rejoice, and you should too, as the new restraint on monetary policy will give way to natural market forces. Real risk-taking should be rewarded, while it would be possible for savers to earn a comfortable 5% to 9% in blended fixed income.

What type of risk premium justifies taking risk then? At ~5% US treasuries, the hurdle is high, but bets are on that it will not stay this way for long.

Market seemed to be up for that. The US 10y treasury yield dropped by 40bps since Wednesday 1Nov23. The reasons for this sentiment are:

  1. the US treasury funding need in 4Q23 and 1Q24 was less than expected
  2. the Fed is pausing rate hikes for now
  3. initial jobless claims as of 28Oct continue to increase, but slowly
  4. non farm payroll, and unemployment number confirmed an economic cooldown

On this sentiment, market rallied across bonds and equities. Bottom-fishing was active in REITS, Banks, Utilities, Consumer sectors and EM. These sectors suffered most from higher US rates and stand to benefit from less pressure on this front.

In the meantime, the current earnings season is confirming economic resilience, and still full of positive surprises. For smaller businesses, where the slowdown is most pregnant, earnings are still exceeding expectations in 7 out of 12 sectors in the current 3Q23 earnings season so far.

So, why worry? There is no reason not to extend fixed income positioning into 2y-5y US treasuries or agency loans, where there is 5% yield if you can get it. Along the same vein, I wouldn’t frown at US corporate debt that on average yields 6.1% with spreads above long-term average. High yield is probably at the end of my comfort zone for now, considering the growing pressure on credit, even though credit specialists would tell me that spreads at 460bps look attractive all the more than riskier credits have been pushed out to private leveraged loans.

With regards to equity, lower rate expectation should be a massive tailwind until the recession becomes more pressing, and it will. You are probably looking at a relief rally for now, and the long-term investor would appreciate lower valuations in anything “value”. The rest of the story will be down to a fundamental analysis on how earnings could be maintained in FY24 through higher volumes, and lower margins.

Remember though that any rate-relief rally is predicated on slower economic growth. In itself, it is a mixed blessing, isn’t it?

Stay safe out there !

About –

360 Advisory LLC is a Boston-based RIA managing investments