Peak-rates euphoria

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Good morning. We hope our American readers had a gluttonous and restorative Thanksgiving holiday. Now we turn to the year’s final stretch, the season of prognostications about the year to come. Before thinking about 2024, however, we take a pause to reflect on where the market stands now. The market has become quite upbeat and, in contrast to our natural pessimism, we think it has some reason to be. Send us your thoughts: robert.armstrong@ft.com and ethan.wu@ft.com.   

Optimism blooms

Most market pundits, ourselves included, did not think the S&P 500 would be up almost 20 per cent in late 2023. Yet here we are. Optimism has roared back in November. After some good inflation news and remarkably sturdy growth, the interest rate peak is in sight. As Katie Martin noted in her weekend column, a record 61 per cent of investors expect lower yields in 2024, according to Bank of America’s popular fund managers’ survey.

The market reaction has been decisive. In the past month, the 10-year yield has fallen 40bp and stocks have risen 10 per cent. This makes sense. The chart below, which we showed you earlier this month, illustrates how correctly calling the peak in past rate cycles prints money:

Rallying stocks and bonds are far from the only signs of optimism. The AAII investor sentiment survey has become sharply bullish in the past month. Bottom-up earnings expectations suggest profits will grow 8 per cent year over year in 2023, followed by 11 per cent profit expansion in 2024. That is no recession, and hardly a slowdown either. Goldman Sachs’s preferred measure of how stock markets price economic growth, comparing cyclicals versus defensives, implies sprightly 2 per cent real GDP growth:

Corporate credit reflects the market mood, too. With fund flows into corporate bonds, especially into high yield, sitting at three-year highs, absolute yields have fallen this month. High-yield spreads over Treasuries remain subdued: 3.9 per cent versus the historical average of 5.4 per cent. Investors are not getting paid much to take on credit risk. Instead, the bet is that bond investors will enjoy a capital gain from falling yields while growth resilience keeps defaults low. It is a duration play for a soft-landing world.

Some readers might wonder how markets can feel so optimistic while investor cash allocations are high, traditionally a sign of elevated caution. And it is true that a boatload of investor money, nearly $6tn, is sitting in money market funds right now. The recent rise in inflows to cash funds is impressive (chart from BofA):

This, though, may say more about the lure of higher rates than defensive posturing. As rates departed from the zero lower bound, possibly for good, cash has gone from trash to a proper asset class. Flows have followed. Some cash in money markets may get redeployed towards risk assets, but today’s high cash balances don’t necessarily contradict risk-on sentiment.

Another knock on this market is that it is not as strong as it appears, in that almost all the gains of the S&P 500 come from the magnificent seven tech stocks. The equal-weighted S&P is barely up for the year and 10 per cent below its peak of January 2022, evidence (to some) of underlying gloom. We see it a different way. The whole market had an astonishing run in 2020 and 2021, which drove valuations to wild highs. Earnings are only now catching up. The notable thing is not that most stocks have consolidated and moved sideways for a couple of years after a wild rally. It is that a handful of very large stocks, representing more than a quarter of the market, has continued to rise.   

What could go wrong? 

We think the market’s optimism rests on reasonably good foundations. Three weeks ago we argued in some detail against the “Wile E Coyote” view that the economy was suspended mid-air over a chasm. The Coyote view holds that only temporary factors have prevented high rates from badly damaging demand. The wonderfully encouraging October inflation report has quieted the coyotes some, as it should. But with that said, it would be foolhardy to disregard the sceptics altogether — especially if the near-universal view that we are at peak rates turns out to be wrong.

And it could be wrong, at the short end of the curve, the long end, or both. On the short end, the market sees a 12 per cent chance that one more 25 basis point hike in place by the Fed’s January 2024 meeting, according to the CME. That would place the policy rate at 5.5-5.75 per cent. The market puts the probability of rates going any higher than that at effectively zero. This makes some sense, with inflation approaching target and the economy in a mild slowdown. But history counsels caution, as Strategas’ Don Rissmiller has been pointing out for some months. In the past, in most countries, a first wave of inflation subsides but gives way to a second. 

Next, there is a risk that because we expect inflation to get back to target and short rates to fall accordingly, long rates — which have risen almost four percentage points from their pandemic lows and about two and a half points from pre-pandemic levels — must also fall. But as Olivier Blanchard pointed out in his recent Unhedged interview, we don’t really know why long rates, and in particular real long rates, have risen as much as they have. Inflation and monetary policy are not an adequate explanation. It could have to do with fiscal irresponsibility, or uncertainty about future real rates, or higher expected inflation volatility, or something else. But if long rates do stay high, especially in the absence of sustained high economic growth, that will have implications for asset valuations, and possibly for economic growth as well. 

One further, totally speculative point. There may be some peak-rates euphoria in the air; a notion that if rate increases subside, risk assets must do well. It is an understandable assumption, given that in the post-GFC era rates were low and risk assets did well. But there is more to markets than rates. (Armstrong & Wu)

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