Post Type: Market Insights

Apr 18th

Market Insights – Second Quarter 2025

A Growth Scare ... And Likely No Worse

The momentum from two years of remarkable economic resilience and strong market returns came to an abrupt halt in April 2025. The catalyst for market turmoil this time around was an unexpected turn in the administration’s global trade policy.

April 2, 2025 was touted as Liberation Day in anticipation of the long-awaited details on President Trump’s reciprocal tariff policy. The President used his executive authority to address the lack of reciprocity in U.S. bilateral trade relationships and to “level the playing field for American workers and manufacturers, re-shore American jobs, expand our domestic manufacturing base, and ensure our defense-industrial base is not dependent on foreign adversaries—all leading to stronger economic and national security” (Office of the United States Trade Representative).

However, the scope and magnitude of the proposed tariffs exceeded all expectations. In the initial Liberation Day proposal, all countries were subject to a minimum tariff rate of 10%. Countries with whom the U.S. has a large trade deficit were subject to even higher reciprocal tariffs.

The immediate reaction to the announcement was an immense fear of a global recession and a spike in inflation. Consistent with these fears, stocks sold off dramatically after the initial announcement. A temporary pause in reciprocal tariffs for all countries except China then halted the stock market decline. However, the U.S. dollar and bond market both fell sharply and unexpectedly during the week of April 7, 2025 in contrast to their conventional safe haven status.

We address concerns about higher inflation, higher rates, a recession, a bear market, and a weaker U.S. dollar in this article.

We are aware that this is a highly charged and contentious topic. We will, therefore, refrain from any ideological, philosophical, political, or moral judgment on the subject. We also realize that public disclosures on the topic may lack full transparency for reasons of national security. In a rapidly changing world, our views here have been penned in mid-April 2025.

How Did We Get Here?

The original impetus for higher tariffs is likely rooted in the fact that almost all of our trading partners charge a higher tariff on our exports to them than we do on their exports to us. For example, 2023 World Trade Organization data estimates that China, India and the UK have tariff rates of around 17%, 12% and 5% respectively on U.S. exports to them. In contrast, our corresponding tariffs on their exports to us are around 10%, 2% and 2% respectively. This mismatch in tariffs is probably further exacerbated by other unfair trade practices such as non-tariff barriers and currency manipulation.

The administration’s policy on tariffs may have been further emboldened by the perceived leverage of the U.S. over many of its trading partners. Figure 1 shows how this leverage is achieved. It compares the importance of a country’s imports to us (x-axis) versus the importance of U.S. exports to its own global trade (y-axis).

Figure 1: Leverage in Trade Relationships

Source: Wolfe Research, World Integrated Trade Solution as of 2022

This chart helps us understand where the U.S. has more leverage with its trading partners. We explain Figure 1 with an example. Take Vietnam for instance. All imports to the U.S. from Vietnam account for only around 4% of total U.S. imports. However, those same Vietnam exports to the U.S. account for almost 32% of its total exports. In light of this imbalance, Vietnam is far more likely to negotiate than retaliate.

In Figure 1, it is clear that Mexico, Canada and several Emerging Markets countries in Asia and South America are most dependent on trade with the U.S., while countries in the EU have more equal trading relationships. China has the most trading leverage against the U.S.; its retaliation has, therefore, been fast and furious.

These salient data points had already been priced into expectations of a higher tariff rate of around 8% prior to Liberation Day. Nonetheless, markets were caught off guard on April 2nd at two levels—by the methodology of tariff calculations and the resulting magnitude of reciprocal tariffs.

Contrary to expectations of a more targeted approach, the reciprocal tariffs were derived from a rudimentary framework that aimed to reduce bilateral trade deficits. Each country’s tariff rate was determined by dividing the U.S. trade deficit with that country by total imports from that country. This number was then cut in half to create the new U.S. “discounted” reciprocal tariff. Here are some of the initial proposed reciprocal tariffs from Liberation Day: China 34%, EU 20%, Japan 24%, India 26%, Vietnam 46%, Switzerland 31% and UK 10%.

These initial reciprocal tariffs have since been suspended for 90 days for all countries except China from April 10th. In sharp contrast, tariffs with China have escalated exponentially through a sequence of retaliations; they now stand at 145% on Chinese exports to the U.S. and 125% on U.S. exports to China. U.S. tariffs on all other countries temporarily stand at the minimum baseline of 10%.

We summarize the revised April 10th levels of tariffs in Figure 2 before turning to our inferences and forecasts.

Figure 2: Average Effective Tariff Rate as of April 10, 2025

Source: The Budget Lab, Yale University

The average global tariff rate for the U.S. is now projected to go up more than 10-fold from 2.4% to approximately 27%. We label this average tariff rate as a “pre substitution” rate since it assumes that all flows of global trade remain constant and intact at 2024 levels. However, higher tariffs on Chinese goods may well trigger substitution to other cheaper imports. The resulting “post substitution” average tariff rate is lower and estimated to be 19%.

Thoughts on Current Trade Policy

We appreciate the desire to increase the U.S. manufacturing base and reduce foreign dependencies in industries critical to national security. We also applaud the pursuit of fairer terms for global trade.

Nonetheless, we initially believed that it was sub-optimal to achieve these goals with an aggressive trade policy alone. A number of tenets in the opening approach seemed misaligned with our global leadership role, created by our own dominant economy and strong alliances with others.

The costs of high fixed trade barriers are well-known, e.g. higher prices, slower growth, less competition, less innovation, and lower standard of living. The expansive and punitive trade war in its initial formulation on April 2nd risked a U.S. recession and an alienation of our allies.

The singular focus on reducing bilateral trade deficits through high imputed tariffs also felt misguided. A large portion of the U.S. trade deficit is driven by principles of comparative advantage where cost of production is often lower overseas and by cultural differences in our lower propensity to save and greater desire to consume. Besides, the large foreign trade surpluses eventually make their way back into U.S. dollar-denominated assets giving our stocks, bonds and currency hegemonic power.

These thoughts may also have preyed on investors’ minds as they indiscriminately sold risk assets. The S&P 500 suffered a 2-day decline of -10.5% on April 3rd and 4th. It was remarkably the first ever decline of such magnitude to be triggered by a policy initiative during benign times – as opposed to an existing endogenous fundamental crisis (e.g. Global Financial Crisis) or an unexpected exogenous shock (e.g. Covid).

Two recent developments have opened up a different possibility for the intent and scope of the current trade war: 1) The U.S. has rapidly escalated tariffs against China all the way up to 145% and 2) The U.S. has rapidly deescalated tariffs on all other countries down to 10% for 90 days. There may now be some credence to a scenario where the trade war is focused on curtailing China’s economic, manufacturing, scientific, technological, and military might while actually strengthening all other global alliances through reconciliation, collaboration and some coercion.

Future Evolution of Trade Policy

We have maintained since the elections that the bark of proposed tariffs will eventually be bigger than its final bite. We have been clearly surprised by the much louder bark and greater magnitude of the new reciprocal tariffs and the damage they have inflicted on the markets so far. Nonetheless, we still believe they will eventually be implemented at lower levels than the ones proposed on April 2nd.

Excluding China, we reckon that global tariffs will settle in at the 8-18% level. While an extensive and protracted global trade war remains a possibility, it is not our base case.

It would serve both the U.S. and China well to find an off ramp towards a more stable co-existence as the world’s two leading economies. If that doesn’t happen for any reason, it is conceivable that the U.S. may largely shift its trade dependence on China to other countries. As supply chains re-adjust, we expect the tariff shock to fade and be subsumed by the positive fundamentals of higher productivity growth, fiscal stimulus and deregulation.

Impact on the Economy

The direct impact of higher tariffs is clearly inflationary and recessionary. We also understand that high levels of policy uncertainty can take an indirect economic toll from reduced consumer spending, slower hiring and lower capital expenditures.

Since higher prices are tantamount to a tax on households, we begin by estimating the impact of tariffs on disposable incomes. Figure 3 shows the likely impact of the April 10 package of tariffs on disposable incomes across different deciles of household incomes.

Figure 3: Impact of Tariffs on Disposable Income

Source: The Budget Lab, Yale University

The top 10% of households by income (highest decile #10) in Figure 3 is expected to see the smallest disposable income decline of -2%. On the other hand, the lowest decile of household income may see disposable income fall by almost -5%.

Any reduction in consumer spending from a decline in disposable income will likely be uneven and disproportionate across income categories. A -2% decline in disposable income for the highest income households may have virtually no effect on their spending. Since most of the aggregate consumer spending takes place in high income households, we are optimistic about a relatively muted impact of tariffs on growth.

We expect up to a -1% direct impact of tariffs on GDP growth and up to a -0.5% indirect impact. Therefore, we expect GDP growth to be reduced by -1% to -1.5% in 2025. From a strong starting point of 2.5% real GDP growth, we expect 2025 growth will still be above zero even after our anticipated reduction.

While the odds of a recession or “stagflation” have gone up, neither scenario is our base case. We estimate the odds of a recession to be 30%, which is well below the consensus expectation of 60-70%.

It is evident that inflation will likely be higher in 2025, but we expect it to subside in 2026 as the world adjusts to a new global trade order. On a positive note, we observe that inflation expectations for a 5-year period starting in 2030 have actually declined from 2.3% to 2.1% as of April 11, 2025. We believe current Treasury bond prices are overestimating long-term inflation risks.

Impact on the Markets

U.S. Stocks

The U.S. stock market has seen some wild swings in 2025. Here is the most striking statistic we have found on recent stock market volatility: If you add up all the absolute intra day moves of 3% or more in the 3 trading days between April 7th and April 9th, the S&P moved a monumental 52%!

In the midst of such high volatility and uncertainty, it is difficult to form an outlook for U.S. stocks. We give the task at hand our best analytical effort and intuitive judgment by forecasting both expected S&P 500 earnings and P/E multiples.

We have observed over the years that earnings growth for the S&P 500 tends to be 3-4 times U.S. GDP growth. Based on our view above that GDP growth may be lower by -1% to -1.5%, we expect S&P 500 earnings growth may also be lower by around -4% to -5%. Despite a reduction in the earnings growth rate because of tariffs, earnings will still rise in the next 12 months.

We have a more differentiated view on where trough multiples will likely end up. In prior recessions, they have fallen to as low as 10-13x. In non-recessionary growth scares, they have fallen to 15-16x.

We believe trough multiples will be higher during this growth scare. The current economic and market crisis is policy-induced; up to a certain point, the antidote for the crisis also remains in the hands of policymakers. And as a beacon of hope and optimism, we already have light at the end of the tariff tunnel in the form of fiscal stimulus and deregulation. Therefore, we strongly believe the trough P/E multiple will be higher this time at about 18x.

We also know that trough earnings and trough P/E multiples are never coincident; you cannot see them simultaneously. You typically see trough prices first, then trough multiples and finally trough earnings.

With these building blocks in hand, we estimate that a viable floor for the S&P 500 may exist at the 4,900-5,000 level. While we obviously cannot rule out lower prices, we may just about avoid a bear market by remaining above its closing price threshold of 4,915.

Our base case rules out a bear market, expects the current correction will not be protracted and predicts the S&P 500 will deliver a positive return in 2025.

U.S. Bonds and Dollar

The manic turmoil in the U.S. bond and currency markets during the week of April 7th could well be the topic of an entire article. We confine ourselves to a few key observations here.

Treasury bond prices and the U.S. dollar both fell significantly in the second week of April. This is an extremely rare occurrence, and it triggered profound fears that we were at the beginning of the end of U.S dominance in global bond and currency markets. Critics attributed the selloff to fundamental factors ranging from heightened U.S. fiscal risks caused by an imminent recession to a devastating loss of confidence in U.S. institutions and leadership.

We do not believe those factors were central to the meltdown in U.S. bonds and the dollar. Instead, we believe it originated from a more nuanced and niche event in the bond market. It is widely understood that hedge funds were unwinding a very large and highly leveraged “bond basis” trade in the face of low liquidity and high volatility. This forced and rapid liquidation created significant price dislocations in both Treasury bonds and the U.S. dollar.

We expect U.S. Treasury bonds and the dollar to stabilize in the coming weeks. We believe the 10-year Treasury yield should be closer to 4.1-4.2% in the near term and around 4.5-4.6% in the long run.

Summary

We close out our discussion on a positive and optimistic note.

We know from prior experience that high levels of consumer pessimism, policy uncertainty and fear gauges tend to be contrarian in nature. In other words, stock market returns in the aftermath of high pessimism or fear have historically been high. Figure 4 shows the contrarian nature of consumer sentiment.

Figure 4: Consumer Sentiment is Contrarian

Source: University of Michigan, JPMAM, as of April 2025

The latest reading of consumer sentiment nearly reached its all-time low mark of 50.0 on April 11, 2025. While it accurately reflects coincident pain in the economy, it sadly lags the direction of future stock prices.

The stock market tends to look 9-12 months ahead and generally bottoms out when things are at their worst and about to get better. If history is any indication, stock returns over the next 12 months may be handily positive.

We summarize our key takeaways below.

  • We believe final tariffs will be lower than those proposed currently; their impact on inflation, GDP growth and corporate profits will also be lower than currently feared.
  • We assign a low probability to a recession, “stagflation” or a bear market.
  • We do not anticipate a protracted correction in stock prices; we expect the S&P 500 to deliver a positive return in 2025.
  • We believe fears of “de-dollarization” and significantly higher Treasury yields are overblown; we expect the bond market and the U.S. dollar to halt their declines in the coming weeks.

Within client portfolios, we are focused on adding to or buying new high quality securities that have sold off disproportionately in this “tariff turmoil”. In these uncertain times, we remain careful, prudent, disciplined, and prepared to act on emerging opportunities.

To learn more about our views on the market or to speak with an advisor about our services, visit our Contact Page.

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We believe final tariffs will be lower than those proposed currently; their impact on growth and inflation will be lower than feared.

 

We assign a low probability to a recession, “stagflation” or a bear market.

 

We expect the S&P 500 to deliver a positive return in 2025.

 

We believe fears of “de-dollarization” and significantly higher Treasury yields are overblown.

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Mar 26th

Whittier Trust CIO, Sandip Bhagat, Featured on NASDAQ TradeTalks Panel 

Sandip engaged in a healthy debate with top industry professionals and economists about the recent turmoil in the markets as a growth scare threatens to devolve into a recession or stagflation.

Risk assets have sold off in the midst of high policy uncertainty and fiscal austerity from government job cuts. In the span of just a few weeks, concerns about the U.S. economy have shifted from being overheated to now plunging into a recession.

Sandip believes these fears are overblown and unwarranted. The bark of tariffs will likely be bigger than the bite. Renewed fiscal stimulus, deregulation and productivity growth will eventually push growth higher in the coming years.

Watch now to hear Sandip’s more balanced, strategic and constructive outlook in a discussion with Phil Mackintosh, Chief Economist at Nasdaq; Brian Joyce, Managing Director on the Nasdaq Market Intelligence Desk; Steven Wieting, Chief Economist & Chief Investment Strategist at Citi Wealth; and host of Nasdaq Trade Talks, Jill Malandrino.

To learn more about our views on the market or to speak with an advisor about our services, visit our Contact Page.

Jan 22nd

Market Insights – First Quarter 2025

Shifting Gears In The Economic Cycle

The U.S. economy has now remained resilient to the massive post-pandemic inflation shock for well over two years. As a result, the economic outlook has changed dramatically from the inflation peak in June 2022. We trace this progression to assess where we stand now and what lies ahead.

The longest economic expansion on record from 2009 to 2020 established a new, lower trend-line real GDP growth rate of just below 2% for the U.S. economy. Against this benchmark, investor expectations have shifted sequentially through the following four phases of real GDP growth from 2022 onwards.

  • Inevitable recession - Negative growth, well below 0%
  • Soft landing - Below-trend growth, above 0% but below 2%
  • No landing - Trend growth, around 2%
  • “Launch” landing - Above-trend growth, above 2%

We describe the last scenario as a “launch” landing in our lexicon and believe the new post-pandemic economic cycle will normalize at real GDP growth above 2% in 2025 and beyond.

While this evolution of the economic outlook may have surprised many investors, it almost played out as we expected three years ago. We were firmly of the opinion that inflation would subside rapidly as pandemic-induced supply shortages resolved on their own. We believed the U.S. economy had become more insulated from interest rate increases as consumers and corporations locked in low, long-term, fixed rates for their loan obligations. We had all but ruled out a recession and believed that growth was likely to surprise to the upside.

The momentum of the economy in 2024 was strong enough to overcome the uncertainty of the U.S. elections. If anything, the unexpected GOP sweep in November raised hopes of an even stronger economy on the heels of continued fiscal stimulus and deregulation. Company profits in 2024 were almost in line with lofty forecasts and earnings growth expectations for both 2025 and 2026 are still high at 13-15%.

It is no surprise then that the U.S. stock market delivered strong performance yet again in 2024. The S&P 500 index rose by 25.0%; the Nasdaq index, which includes the Magnificent 7 group of technology leaders, gained 29.6%; and the Russell 2000 index of small companies was up 11.5%. In fact, the S&P 500 index has now delivered the rare outcome of back-to-back total returns of at least 25% in two consecutive years.

The continued strength in the U.S. economy and stock market brought a lot of cheer to investors in 2024. However, it has now led to two major concerns in 2025.

Investors got clear evidence in July 2024 that the Fed could soon start cutting interest rates when headline CPI inflation registered its first post-pandemic monthly decline. From that point on, investors aggressively priced in multiple rate cuts under the benign scenario of continued disinflation and solid Goldilocks growth which was neither too hot nor too cold.

These expectations began to unravel towards the end of 2024. As investors began to price in a Trump win and then eventually saw the GOP sweep, interest rates began to rise in anticipation of a number of knock-on effects related to the election outcome.

a. Higher economic growth from continued fiscal stimulus, a new regime of deregulation and technology-led growth in productivity

b. Higher fiscal risks from larger fiscal deficits

c. Higher inflationary pressures from both higher growth and new policies on tariffs and immigration

At the same time, prospects of higher economic growth and higher corporate profits pushed stock prices and valuations higher.

In the last four months (from mid-September to the time of writing), interest rates have risen by more than 1%. Market expectations of Fed rate cuts have now declined to less than two; in fact, many are now assigning a non-zero probability to rate hikes in 2025. And in the stock market, strong returns have pushed valuations higher; the forward P/E for the S&P 500 stood at 21.5 at the end of December 2024.

These data points now pose the following risks to investors.

  1. Will interest rates stay high or go even higher? Will high(er) interest rates bring down the stock market and eventually stall the economy?
  2. Even if the stock market survives the burden of high interest rates, will it buckle under the weight of its own (high) valuations?

We address these two key questions on the way to developing our 2025 economic and market outlook.

Interest Rates

The recent low in the 10-year Treasury bond yield was 3.6% on September 16, 2024. After a strong jobs report on January 10, 2025, the 10-year Treasury yield almost reached 4.8%. This 1.2% increase is significant because it is unusual for long-term rates to move higher after the onset of a Fed easing cycle.

We see this historical anomaly more clearly in Figure 1.

Figure 1: 10-Year Treasury Yield Before and After First Fed Cut

Source: FactSet; Average includes rate cuts from June 1989, September 1998, January 2001, September 2007 and July 2019; as of January 10, 2025

Long-term interest rates normally decline when the Fed starts cutting rates. The simultaneous decline in both short-term and long-term interest rates is intuitive. Fed rate hikes usually slow the economy down to the point where rate cuts become necessary to prop it up. Fed rate cuts normally coincide with economic weakness and, therefore, a decline in long-term rates.

The divergent trend in Figure 1 is another reminder about the inefficacy of monetary policy in this economic cycle. At the outset, post-pandemic inflation was more attributable to supply side disruptions and fiscal stimulus than it was to monetary stimulus. Then, Fed rate hikes and higher interest rates didn’t cause the type of demand destruction that one would have normally expected. And now, expectations of higher growth are being driven by factors other than monetary policy.

We make an argument in the following sections that we are shifting to a higher gear of growth in this economic cycle. We observe in passing that the drivers of economic growth are also shifting. We believe the baton for higher future growth has now been handed off from monetary policy to higher productivity growth, deregulation and fiscal stimulus.

The first stage of our interest rates analysis is to understand why they are going up.

Nominal interest rates are comprised of two components: 1) inflation expectations and 2) real interest rates. We look at each of these factors separately.

Inflation Expectations

Under normal conditions, the 10-year Treasury yield will generally exceed inflation expectations for the next 10 years. Longer term policies drive these inflation expectations more than shorter term trends. In the current setting, inflation fears have been elevated by prospects of higher growth, immigration policies that may reduce the supply of workers and the implementation of proposed tariffs.

We do not believe that 10-year inflation expectations have changed materially in the last few months. For a while now, we have thought the Fed’s 2% inflation target was likely to be elusive. Our fair estimate of 10-year inflation expectations is slightly higher at around 2.25%.

We believe the market is mispricing a higher level of expected long-term inflation. We support our more benign view on inflation with the following observations.

i. We know high universal tariffs can be inflationary and harmful to domestic growth. We don’t believe they will be implemented as originally proposed; they will ultimately be selective, targeted and reciprocal. We believe the threat of tariffs is likely a negotiating tactic; it is aimed more at opening up foreign markets than at sourcing revenue. The bark of expected tariffs will probably end up being a lot worse than its actual bite.

We believe that the impact of immigration policy on the economy will also be less severe than anticipated.

ii. Inflation has been trending higher in recent months. We believe there may be some unusual base effects at play in these short-term trends. CPI prices fell in the fourth quarter of 2023, then rose sharply in the first quarter of 2024 and have been fairly steady thereafter. As a result, year-over-year changes in CPI inflation may come down in the coming months.

In any case, these recent trends are unlikely to materially affect inflation over the next 10 years. Counter to growing investor concerns, expectations for 5-year inflation, starting in 5 years from now, have remained well-anchored at about 2.3% even as long rates have gyrated violently.

iii. And finally, we maintain our high conviction that technology will continue to create secular disinflation in the coming years. We are hard pressed to think of enough inflationary tailwinds to overcome this one powerful disinflationary force.

We next look at the other potential drivers of the increase in long-term interest rates.

Real Interest Rates

Real interest rates are primarily influenced by long-term changes in the level of economic activity. Increases in economic growth rates cause the real interest rate (and, therefore, the nominal rate as well) to increase and vice versa. In fact, one of the more useful heuristics in the capital markets is that long-term nominal interest rates are typically bounded by the long-term nominal GDP growth rate expectations.

For the sake of completeness in our analysis, we make a small detour here to resolve one other nuanced driver of changes in real interest rates — changes in the risk premium. If investors perceive fiscal risks to be higher, they will in turn demand a greater compensation for bearing that risk through higher interest rates.

There is a great deal of angst that the incoming administration will continue to increase government spending and the fiscal deficit. We tackled this concern about greater fiscal risks comprehensively in our 2024 Fourth Quarter Market Insights publication.

For a myriad of reasons, we concluded that fiscal risks are not as elevated as feared and unlikely to trigger higher inflation or higher interest rates. We believe that any pricing of a higher risk premium into higher nominal yields today is unwarranted.

We resume our focus on the topic of economic growth.

In a material shift in our thinking, we now see the U.S. economy shifting to a higher growth gear in the next decade. In the pre-Covid economic cycle, real GDP growth in the U.S. averaged an anemic sub-2%. We expect real GDP growth will now exceed 2.5% over the next 2-3 years and conservatively average 2.25% over the next decade.

These forecasts imply an upward shift of at least 0.5% in real GDP growth from the prior cycle. At first glance, this may seem overly optimistic because of the obvious headwind of an ageing population.

We know the natural or potential growth rate of an economy has two basic components: 1) growth in the labor force and 2) productivity gains of existing workers. We concede that unfavorable demographics and potentially adverse immigration policies will likely reduce the size of the future labor force.

This places the onus for higher GDP growth squarely on the second factor of increased productivity. In fact, with flat to negative growth in the labor force, productivity will need to increase by 0.5-1.0% to boost GDP growth rates by 0.5% or more. How feasible is this outcome and why?

We make the following arguments numerically and fundamentally to support the feasibility of such an outcome. We begin with a look at trends in productivity growth going back about 75 years in Figure 2.

Figure 2: Productivity Changes in the Non-Farm Business Sector

Source: U.S. Bureau of Labor Statistics; as of December 2024

The light blue bar in Figure 2 shows the average annual productivity growth rate in the last 75 years is 2.1%. However, productivity growth does fluctuate a lot around this long-term average. As a rule of thumb, it declines during recessions and periods of slow growth (1970s and the Global Financial Crisis – GFC) and rises during periods of growth and innovation (1980s and 1990s).

We can also see that big swings in productivity growth rates of +/-1% are feasible. Productivity growth rose by more than 1% during the era of Internet Innovations and fell by more than 1% post-GFC.

We believe the new post-Covid economic cycle will foster both innovation and growth for a number of reasons. Technology was deployed at a rapid pace during the pandemic with a positive impact on business operations e.g. hybrid work arrangements, automation and robotics.

Recent advances in AI have also set the stage for significant productivity gains in the coming years. Investments in AI so far have focused on the “infrastructure” phase to facilitate training, learning and inference. We are now moving into the “application” phase where AI systems and agents will monetize this infrastructure to create practical solutions and economic value across the enterprise.

Finally, stimulative deregulation policies from the new administration will also streamline business processes and unlock operational efficiencies. The trifecta of technology, AI and deregulation can easily unlock an increase in productivity growth of approximately 1%.

Our forecast for the real interest rate over the next 10 years is 2.25%, in line with our real GDP growth estimate.

We now have forecasts for both inflation expectations and the real interest rate. Coincidentally, they are both around 2.25%. Our fair estimate for the 10-year Treasury yield is simply the sum of these two components.

We expect the 10-year Treasury yield will settle in the 4.5-4.6% range by the end of 2025. We don’t expect it to go much higher than the 4.8% level of January 10; it will instead recede by a small margin.

We are clear that an increase in real rates is a bigger factor in driving interest rates higher than a change in inflation expectations. We do not believe that inflation is headed higher; it will instead move lower in a bumpy manner. Based on our inflation outlook, the Fed will have more room to cut rates in 2025.

Higher real rates signal a stronger, healthier economy. Stronger economic growth bodes well for corporate profits. We believe that our inflation forecast of 2.25% and 10-year Treasury yield forecast of 4.5% will still be supportive of stock prices.

We close out our analysis and outlook for 2025 with a look at stock market fundamentals.

Stock Market Valuations

U.S. stocks have performed well in the last two years. While their returns have been naturally rewarding, those same high returns have also created risks going into 2025.

On the heels of two consecutive years of at least 25% total returns, U.S. stocks now appear expensive. Many valuation metrics are in the highest quintile of their historical ranges. We take a closer look at a couple of these valuation measures.

At the outset, we acknowledge the topic is complicated and nuanced. Our research is always deep, thorough and rigorous. However, our insights here are curtailed by the finite scope of this article.

We are mindful that the four most dangerous words in investing are widely believed to be “this time is different.” And yet, we also know that a number of time-tested paradigms haven’t worked in the post-pandemic economy and markets. The absence of a recession so far on the heels of an inverted yield curve even after a long lag of two years is a case in point.

We do our best to straddle this balance between respecting historical norms and yet thinking creatively and fundamentally about what might indeed be different this time around.

A commonly used valuation indicator was originally identified by Warren Buffett in a 2001 Fortune magazine essay. The Buffett Indicator measures the market value of all publicly traded U.S. stocks as a percentage of U.S. GDP. When the metric is high, stocks are vulnerable to a sell-off.

The Buffett Indicator has attracted significant attention in recent weeks as it went surging past a level of 200%. In other words, the market capitalization of all U.S. stocks is now more than double the level of total U.S. GDP. The Buffett Indicator suggests that U.S. stocks are now significantly over-valued.

We respect the broad message here that U.S. stocks are not cheap. However, we believe that a couple of relevant insights provide a more balanced perspective on this valuation metric.

The Buffett Indicator is anchored only to U.S. GDP in its denominator. However, many U.S. companies compete effectively in foreign markets. Since a growing number of U.S. companies are multi-national, a material and increasing portion of S&P 500 earnings is generated overseas. Clearly, the market value of all U.S. stocks in the numerator is not bounded by just the size of the U.S. economy. This mismatch causes the Buffett Indicator to rise steadily over time.

We look at another fundamental difference over time that may more rationally explain the trend in the Buffett Indicator.

We know stock prices follow corporate profits; as go profits, so do stock prices. Much like the construct of the Buffett Indicator, we track U.S. corporate profits as a percentage of GDP in Figure 3.

Figure 3: U.S. Corporate Profits as a Percent of GDP

Source: U.S. Bureau of Economic Analysis; as of Q3 2024

U.S. companies have continued to become more and more profitable. Almost analogous to the doubling of the market value of all U.S. stocks as a percent of GDP, U.S. corporate profits as a percent of GDP have also nearly doubled from 6.0% to 11.3%.

We believe these fundamental connections between the growth of U.S. corporate profits and the rise in U.S. stock values help us better understand and interpret the Buffett Indicator.

In a similar vein, the Forward P/E (“FPE”) multiple has attracted a lot of attention in recent months. At 21.5 as of December 2024, it is also in the highest quintile of its historical range.

There are two concerns related to the FPE ratio. One, it relies on future earnings (“E”) that were already deemed lofty before the rise in interest rates. And two, even if E comes through as expected, the FPE ratio itself is at risk of compressing through a decline in prices (“P”). We address each of these risks separately.

We have already made our case for a higher gear of growth in the preceding sections. The sustainable spurt higher in real GDP growth from a revival of productivity growth should also spill over into earnings growth.

Consensus analyst forecasts call for an earnings growth rate of 14.8% in 2025 and 13.5% in 2026. We believe these growth rates can be achieved; there is still room for profit margins to expand and augment higher economic, productivity and revenue growth.

We are in general agreement with the market that the P/E ratio will decline in the coming months. We also know that higher starting valuations lead to lower future returns. We are clear that stock returns going forward will be more muted than those seen in recent years.

However, we disagree with the market on both the likely magnitude and speed of decline in the P/E ratio. Investors worry that the 2024 FPE multiple of 21.5 could slide all the way down to its long-term average of around 16. They also fear that the resulting bear market could unfold quickly over just a few months.

We believe that the compression of the FPE multiple will be neither so drastic nor so abrupt. U.S. companies are now more profitable than they have ever been; aggregate free cash flow margins exceed 10% and return on equity is almost 20%.

On the heels of secular innovation, growth and profitability, we believe the fair value of the S&P 500 FPE multiple is now higher at 18-19. We also believe that any decline in the FPE from 21.5 to 18-19 will be more gradual. We expect positive earnings growth to offset the more orderly compression of the FPE multiple.

We illustrate the difference in our stock market forecast and the market consensus in Figure 4.

Figure 4: S&P 500 Forward P/E Ratios and Subsequent 10-Year Returns

Source: Bloomberg; from 1988 onwards; as of December 2024

Figure 4 shows the historical association between the FPE ratio and subsequent 10-year returns from 1988 onwards. A quick visual inspection validates our intuition. Higher initial valuations do lead to lower future returns.

The historical data is heavily influenced by two mega crises that took place just a few years apart – the Bursting of the Internet Bubble (BIB) in 2000-2002 and the GFC in 2007 2009. In each instance, earnings declined significantly as did stock prices and valuations.

The empirical relationship in Figure 4 suggests that the current FPE ratio of 21.5 (shown by the grey vertical bar) may lead to stock returns as meager as 2-3% annualized over the next 10 years. A key assumption in this projection is that both earnings (E) and valuations (FPE) will fall as dramatically as they did in the BIB and the GFC.

Our fundamental analysis does not reveal significant downside in E or the FPE multiple. Our earnings outlook identifies more positive fundamentals (e.g. growth in profit margins and productivity) than negative ones (e.g. excessive leverage). We also believe that the fair value of the S&P 500 FPE ratio is now fundamentally higher than it was in prior decades.

We, therefore, expect a higher stock market return over the next 10 years in the range of 8-10% shown by the red bar in Figure 4. We believe that earnings growth of 8-10% and a dividend yield of 1-2% will offset valuation declines of 1-2% annually in the coming decade.

Our stock market outlook for 2025 is also optimistic. We believe expected earnings growth and the dividend yield will create a tailwind of almost 15%. Since interest rates have moved sharply in recent months, we realize the valuation compression in the near term may be as large as -5%. We aggregate these drivers to forecast a 10% total return for the S&P 500. We expect the S&P 500 to reach a level of 6,400 by the end of 2025.

We conclude with a summary of our outlook for the economy, inflation, interest rates and the stock market.

Summary

The economic and market outlook is becoming less dispersed and more homogenous across investors. As an example, there are virtually no proponents of a recession today. It is harder to offer too many differentiated views against such a backdrop.
We summarize the key tenets of our outlook here.

Economy

  • We expect real GDP growth of 2.5% or above in the next 2-3 years in a significantly pro-growth regime.
  • Real GDP growth will normalize at a level of around 2.25% over the next 10 years.
  • We see a clear shift in the drivers and gears of economic growth. The impetus for higher growth in this cycle will come from deregulation, fiscal stimulus and an increase in productivity growth of 0.5-1.0%.

Inflation

  • We do not see an inflection in inflation up to higher levels.
  • Inflation should subside in a bumpy path to the 2.3-2.4% level by the end of 2025.
  • We believe the fair value for inflation expectations over the next 10 years is 2.25%.
  • We believe the market is mispricing a higher level of future inflation.
    • The impact of tariffs and immigration will be more muted.
    • Meaningful base effects will pull inflation lower in the second half of 2025.
    • Technology will continue to be a powerful secular disinflationary force.

Interest Rates

  • We estimate the real interest rate to be around 2.25% over the next 10 years.
  • We believe the fair value for the 10-year Treasury yield is 4.5-4.6%.
  • The bond market is overestimating the risk premium related to a perceived increase in fiscal risks.
  • Interest rates are likely to come down from their 4.8% level.
  • Based on our inflation outlook, the Fed will have more room to cut rates. We expect 3-4 rate cuts by the Fed in 2025.
  • A Fed policy misstep in the form of rate hikes or bond yields above 5% as a result of overzealous bond vigilantes could trigger a financial accident and curtail growth.

Stock Market

  • We believe that earnings growth and valuation fears in the stock market are overblown.
  • As a result, our expected returns for stocks are higher than consensus over both the 1-year and 10-year horizons.
  • We expect valuations to come down but not as dramatically or quickly as investors fear.
  • We believe earnings growth will match or exceed expectations in the near term.
  • We expect the S&P 500 to reach 6,400 by the end of 2025 and generate a 10% total return.
    • Earnings growth and dividend yield will create a nearly 15% tailwind for stocks in 2025.
    • Multiple compression of around -5% will detract from stock returns in 2025.
  • We expect U.S. stocks will generate annual returns of 8-10% over the next 10 years.
    • We reject the view that a severe valuation overhang will limit annual U.S. stock returns to 2-3% over the next 10 years.

We respect the difficulty of forecasting during normal times, and especially so in the midst of uncertainty. We will assimilate these views into our investment decisions with appropriate caution and adequate risk control.

We believe that 2025 will finally see a normalization of the U.S. economy after the recent pandemic and inflation shocks. We look forward to the prospects of investing in more normal markets.

To learn more about our views on the market or to speak with an advisor about our services, visit our Contact Page.

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We expect real GDP growth of 2.5% or above in the next 2-3 years in a significantly pro-growth regime.

 

We believe the fair value for inflation expectations over the next 10 years is 2.25%.

 

We believe the fair value for the 10-year Treasury yield is 4.5-4.6%.

 

We expect U.S. stocks will generate annual returns of 8-10% over the next 10 years.

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Oct 25th

Identifying the Key Traits of Market Disruptors

Typically, in portfolio asset allocation, the concept of diversification is deemed beneficial to avoid stock-specific risk.  There have been many academic studies supporting this concept.  Although diversification makes sense from a “risk-return” perspective, to have robust performance and beat benchmarks consistently, investors should find stocks that they are willing to hold in a sufficient portfolio weight that will consistently outperform benchmarks.  With the S&P 500 averaging 8-10% annual returns, finding stocks that provide upside over the index is not an easy task.

Nevertheless, the one way we have found to accomplish this objective is to take positions in stocks that are disruptors - disrupting their industries or even creating new ones and fulfilling customer needs better than the competition.  This means companies that are innovating in such a unique way over the longer term that the competition just cannot keep up.  These companies rapidly gain market share from incumbents or even establish new end markets where there is little competition.   

The modern-day example of such disruption is Nvidia. Most know the semiconductor industry was dominated by Intel for the majority of the late 20th century and into the 21st.  Intel focused on central processing units (CPUs) that were the “brains” of personal computers, notebooks and servers.  Intel relied upon Moore’s law, created by former Intel CEO Gordon Moore, which involved the doubling of computing power every two years. This worked well as the personal computer (PC) proliferated in global society and, later, as internet usage grew.  Intel dominated its end markets and had few viable rivals.

But as Moore’s law reached its peak, Nvidia has taken the crown of the world’s largest semiconductor company by making its graphics unit processors (GPUs) more functional to manage the demands of artificial intelligence (AI).  Nvidia’s semiconductors can work together in an array to create massive computing power and exceed the limits under Moore’s law.  In addition, Nvidia management has indicated a doubling of computing power essentially annually with each generation of AI-based GPUs.  

Such innovation has led to massive revenue growth with FYQ12025 (April) sales growth of over 262% and adjusted earnings per share growth of over 573%.  Nvidia has been a clear disruptor in the semiconductor industry and remains at the forefront of AI innovation likely for many years in the future. 

This is akin to Apple Inc.’s performance under former CEO Steve Jobs.  On June 29th, 2007, Apple introduced the iPhone which clearly took the smartphone concept to a new level.  Apple sales growth and stock price appreciation have been phenomenal from that date forward with an annualized revenue run rate just for iPhones of almost $200 billion (as of June 30, 2024) and the stock up 6000% (60x return) since the introduction.

So, what are some common denominators to successfully invest in disruptive companies?

We focus on the following:

  • A Visionary CEO 
  • High Growth or Nascent Industry That Will Be Very Large
  • Company’s Approach to Industry is Disruptive to Incumbents
  • Advantage(s) Will Last for Long-Term – Creating a Moat
  • Growing Free Cash Flow & Improving ROIC

1. Strong CEO Who is A Visionary

A visionary CEO is one of the most important things to look for when investing in the stock of any company, no matter the sector.  There have been many instances where a visionary CEO was replaced by one who was not so prescient or insightful.  These instances have typically led to the failure of the stock. We can point to many examples, with one of the most recent being Disney.  CEO Bob Iger led Disney from March 2005 and retired at the end of 2021.  Disney’s board chose Bob Chapek as Iger’s successor.  The company went from a well-run entertainment conglomerate to one that had lost its competitive advantages in many end markets.  Disney stock declined about 40% in less than a year under Chapek. Luckily, Iger returned in November 2022 with Chapek’s inauspicious dismissal.

2. High Growth Industry

A strong company in a weak industry is usually a poor investment.  Rather, the “secret sauce” is to own a “strong company in a strong industry”.  This typically indicates a market share gainer with a large total addressable market (TAM).  Nike’s rise to become the premier athletic shoe supplier was based on taking market share in an industry with an exceptionally large TAM. The same has been true for other disruptors like Nvidia, Meta, Eli Lilly and other stock success stories.

3. Disruption of Incumbents

On the introduction of the iPhone in June 2007, cellphone market leaders included Nokia, Motorola, Samsung, and LG.  As discussed above, the iPhone was a giant leap forward in terms of both communication and computing.  Apple’s growth under both CEO Steve Jobs and Tim Cook has been astounding, allowing Apple stock to surpass $3 Trillion in market capitalization.  The first iPhone disrupted the cellphone market and created the world’s largest company by market capitalization.  An investment of $100,000 at the introduction would be worth almost $5,800,000 today!  There are many other examples of such industry disruption from Netflix for consumer entertainment to Chipotle for burritos.

4. Advantage(s) Will Last for Long-Term – A Moat

Any investment that does not offer a long-term advantage is arguably a trade.  Trades are attractive to many investors but will not typically provide outsized gains, especially after short-term capital gains taxes are paid.  Companies that are disrupting need a large “moat” to make sure their competitive advantages remain intact over the long term to generate outsized stock returns.  This can be through patents and licensing (although enforcement internationally has been difficult), a superior customer interface or proprietary software (such as iOS for Apple or Cuda for Nvidia), or other means.  Nvidia’s annual product cycles which entail massive improvements in performance and efficiency for AI systems (as seen with the transition from the Hopper generation of GPUs to Blackwell late in 2024 and with Rubin planned in 2025) are the latest method demonstrated to maintain a long-term technological lead over competitors.

5. Growing free cash flow & Improving ROIC

Ultimately, companies that are disrupting their industries should show extraordinary improvement in their financial metrics i.e. they need to generate outsized returns for investors.  Some metrics to judge success are growth in free cash flows and return on invested capital (ROIC).  These metrics allow an investor to monitor company progress in an impartial fashion.  Improvement in both metrics over time should result from a successful industry disruption. Improvements in net margin also should be tracked.

Conclusion

Companies that are disrupting their industries have the possibility of adding outsized equity performance in a diversified equity portfolio.  There are many historical examples including Apple, Starbucks, Nvidia, Nike, Netflix and others whose CEOs and/or founders out-innovated and tactically outperformed peers to either create massive new markets or garner massive shifts in existing market share.  Undoubtedly, there will be new examples in the future.  Finding such companies early in their growth cycles is a key to future investment success.

To learn more about Whittier Trust's market insights, investment services and portfolio philosophies, start a conversation with a Whittier Trust advisor today by visiting our contact page.

 

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Oct 17th

Market Insights – Fourth Quarter 2024

How Heavy is the U.S. Debt Burden?

The last several months have seen a steady drumbeat of data to validate both declining inflation and a slowing economy. CPI inflation for June posted a significant milestone with its first negative monthly print since the depths of the pandemic in Q2 2020.

The remarkable deceleration of inflation in the last two years has allowed the Fed to shift focus within its dual mandate. With inflation on track towards the Fed’s 2% target, the Fed has now started an easing cycle to address and halt continued economic weakness.

Even as lower inflation and the onset of monetary easing now become tailwinds for the economy, a number of market headwinds still persist. These include: 1) stock valuations that are higher than normal, 2) escalating geopolitical risks, especially in the Middle East, and 3) mounting uncertainty around the outcome and policy implications of the U.S. elections.

One of the biggest concerns surrounding the elections is the potentially negative impact of both candidates’ campaign promises on an already high level of U.S. national debt. Neither candidate has come across as fiscally responsible; their fiscal profligacy is instead projected to increase government spending by an additional $5-7 trillion over the next 10 years.

The national debt is a topic of great interest and worry to many people. We focus exclusively on fiscal policy risks in this article.

We recognize that this is a highly charged and potentially contentious topic. We refrain from any ideological, philosophical, political or moral judgment on the topic; our views are focused only on the likely economic and market impact of the U.S. debt burden.

We interchangeably refer to the national debt as total public debt from hereon and set out to answer the following questions.

  • How has the U.S. total public debt grown and who are its main holders?
  • How vulnerable are U.S. interest rates to demands for a higher risk premium i.e. greater compensation for bearing risk?
  • Has the higher debt level contributed to higher economic growth and national wealth?
  • How onerous is the current debt burden and what milestones would further exacerbate fiscal risks?

Sizing the U.S. Debt Burden

The most eye-catching depiction of rising government debt is the nearly six-fold increase in its dollar value over the last 25 years. Total public debt has risen from just under $6 trillion at the turn of the century to almost $35 trillion by June of 2024.

Most of this debt was issued to stabilize the U.S. economy from two devastating shocks during this time – the Global Financial Crisis (GFC) in 2008-09 and the global pandemic in 2020. Since stability of economic growth is a key goal of fiscal policy, the most commonly used metric for the U.S. debt burden is the ratio of total public debt to Gross Domestic Product (GDP). Figure 1 illustrates how total public debt as a percent of GDP has grown over time.

Figure 1: Total Public Debt as a Percent of GDP 

Source: Federal Reserve Board of St. Louis, June 2024

The debt-to-GDP ratio has doubled from almost 60% prior to the GFC in 2008 to around 120% in 2024.

It is interesting to note the different trajectories of the debt-to-GDP ratio after the last two crises.

a. GDP growth after the GFC was anemic as it got dwarfed by an extensive deleveraging cycle.

Slow GDP growth post-GFC caused the debt-to-GDP ratio to spike up rapidly from 60% to 100%.

b. Unlike the GFC which was triggered by unsustainable fundamental excesses, the Covid recession was caused by a global lockdown stemming from health safety considerations. Growth rebounded quickly when economies reopened and was further bolstered by government spending.

Faster post-pandemic GDP growth has contributed to a slower increase in the debt-to-GDP ratio from 100% to 120%.

Most people are alarmed and worried about this rapid increase in the national debt. At first glance, their concerns appear to be well-founded. High and rising government debt could reduce private investment, lead to higher inflation and interest rates, reduce economic growth, weaken the currency, limit future policy flexibility, and create inter-generational inequities.

We analyze these risks by looking at who owns this debt and why, what might make U.S. government debt attractive even at these levels, and whether this level of debt can produce any economic benefits.

Contrary to most prevailing opinions, we believe the fiscal outlook is not nearly as dire. We see no meaningful risk to growth, inflation, interest rates or the dollar in the foreseeable future of 3 to 5 years.

We begin by understanding the composition of the national debt.

Who Owns the U.S. Debt and Why?

Mix of U.S. Debt Holders

Figure 2 shows the two main categories of the gross national debt: debt held by the public (i.e. debt owed to others) and debt held by federal trust funds and other government accounts (i.e. debt owed to itself).

Figure 2: Composition of Gross National Debt

Source: U.S. Department of Treasury, December 2023

Of the $34 trillion in national debt at the end of 2023, $7 trillion, or 21%, was intragovernmental debt which simply records a transfer from one part of the government to another. Intragovernmental debt has no net effect on the government’s overall finances.

In Figure 3, we take a closer look at the remaining 79%, or almost $27 trillion, of the gross national debt which is held by the public. This portion is generally regarded as the most meaningful measure of debt since it represents Treasury borrowings from outside lenders through financial markets. Debt held by the public was 96% of GDP at the end of 2023.

Figure 3: Composition of Debt Held by the Public

Source: U.S. Department of Treasury, December 2023

Almost 70%, or $19 trillion, of the debt held by the public is in the hands of domestic institutions. The remaining 30%, or $8 trillion, is held by foreign entities, split almost equally between foreign private investors and foreign governments.

We examine the motivations of these entities for holding the national debt now and in the future.

Many Reasons to (Still) Hold U.S. Government Debt

Figure 3 shows that the single largest holder of the U.S. national debt is the Federal Reserve Board. When policy rates reached their zero lower bound in 2020, the Fed lowered long-term interest rates by buying bonds. As a result, the Fed still holds more than $5 trillion of U.S. government bonds. It is safe to assume that the Fed is a reliable lender to the Treasury and is unlikely to trigger a sharp increase in interest rates through its own actions.

Mutual funds own more than $3 trillion of U.S. government bonds to achieve diversification in investment portfolios. U.S. government bonds are among the few investments that can protect portfolios during downturns. The safety and long “duration” of U.S. Treasury bonds typically enable them to appreciate when stocks decline during a selloff.

Corporate and public pension funds typically have long-term liabilities to meet the pension obligations of their retirees. As a safe long-duration asset class, U.S. Treasury bonds are a core building block for pension funds to hedge their long-duration liabilities.

Japan and China are the two largest foreign holders of U.S. government debt. Low domestic interest rates in Japan make U.S. bonds particularly appealing for Japanese investors. China runs a large current account surplus, primarily from its favorable trade imbalance of exporting more than importing. China is a natural buyer of safe-haven assets for its more than $3 trillion of foreign exchange reserves.

Unlike the U.S. consumer, foreign consumers tend to save more. This results in a glut of global savings that is simultaneously seeking safety, quality, income, and liquidity. There is no other bond market in the world that offers the size and safety of the U.S. bond market. Figure 4 illustrates the relative size of the world’s largest bond markets.

Figure 4: The World’s Top Bond Markets

Source: BIS, Visual Capitalist, Q3 2022

The U.S. bond market is valued at more than $50 trillion and represents nearly 40% of the global bond market. China’s bond market carries risks of fundamental weakness, currency depreciation and capital controls. The Japanese bond market offers unattractively low interest rates. The remaining bond markets are so small that they do not offer a viable alternative to U.S. bonds.

Now, we take a quick look at the empirical evidence on risks associated with high debt and deficit levels.

High debt and deficits are intuitively associated with high inflation and interest rates. It seems reasonable that greater government spending could spur demand and trigger inflation; it could also curtail private investments from the “crowding out” effect of higher interest rates. Any subsequent tightening to tame inflation would then further slow growth down.

It turns out that this storyline has indeed played out a number of times in high-inflation developing economies. However, it may surprise many of our readers to learn that this is not the norm in low-inflation advanced economies 1. It certainly hasn’t been the case in the U.S. for several reasons.

The U.S. central bank is highly regarded and enjoys strong global credibility. The Fed successfully kept long-term inflation expectations anchored even as inflation reached 9% in 2022. The big increase in total public debt to GDP from 60% to 100% in the aftermath of the GFC didn’t stoke inflation in the ensuing economic recovery.

The U.S. also has solid governance mechanisms to guard against excessive fiscal dominance; two political parties and two independent chambers of Congress provide institutional checks and balances. The U.S. dollar enjoys significant advantages from its status as the world’s reserve currency. The U.S. is home to many of the most innovative and profitable companies in the world, is blessed with abundant natural resources, and boasts a strong military presence.

We are mindful that high levels of borrowing carry inherent risks and that they cannot keep growing endlessly without consequences. However, at this time, we are hard-pressed to pinpoint a specific threshold at which U.S. government debt would become undesirable or untenable.

From a strictly economic perspective, we believe the current level of U.S. national debt is not particularly problematic.

i. Excluding intragovernmental debt and debt held by the Fed, the U.S. debt-to-GDP ratio falls from 120% to 77%.

ii. The remaining domestic and foreign investors have strong incentives to hold U.S. bonds for safety, liquidity, diversification and hedging needs; in any case, there is no viable alternative to the U.S. bond market.

We conclude with a quick look at how the recent increase in total public debt has coincided with economic or market gains.

National Debt and National Wealth

In the four years from 2019 to 2023, total public debt rose from $23.2 trillion to $34 trillion, while nominal GDP grew from $21.9 trillion to $28.3 trillion. The post-Covid annual growth rate of 6.5% in nominal GDP was a lot higher than the meager 4% annual growth from 2009 to 2019.

A number of factors were different in these two periods. A long cycle of deleveraging restrained growth in the post-GFC recovery. An equally powerful theme in this recovery is the significant, but still nascent, impact of technology and AI on the economy and markets. Over the last few years, pandemic-related health safety needs have spurred numerous technological innovations and inventions.

There is a school of thought that our current GDP measurement may not fully capture all the benefits of technological advancements. We will explore this theme in a different setting at a different time. But for now, this notion prompts us to examine the association of debt levels with other measures of well-being or monetary gains.

In this setting, we identify the U.S. national wealth as a useful measure of prosperity. National wealth aggregates the total nominal value of assets and liabilities across all sectors of the U.S. economy. These assets include real estate, corporate businesses and durable goods; liabilities include foreign claims on U.S. assets.

Figure 5 shows the rapid rise in both national wealth and national debt.

Figure 5: Growth of National Wealth and National Debt

Source: Federal Reserve Board of St. Louis, June 2024

The two biggest components of national wealth, by far, are real estate and domestic businesses. We have long argued that one of the key factors behind the resilience of the U.S. consumer is the wealth effect. Home prices and stock prices are at all-time highs and, as a result, so is household net worth. The top quintile of households by income, who account for more than half of all consumer spending, have particularly benefited from the wealth effect.

Several factors have contributed to the rise in national wealth. It is difficult to ascertain exactly what role the fiscal stimulus may have played in its recent rapid growth. However, we do believe that fiscal policy has contributed in some positive manner to the growth in national wealth.

We look at national debt as a percent of national wealth in Figure 6.

Figure 6: Steady Debt to Wealth Ratio in Last 15 Years

Source: Federal Reserve Board of St. Louis, June 2024

The dollar value of both the national debt and national wealth has nearly tripled from 2009 onwards. As a result of the synchronized growth rate in both metrics, total national debt has held steady between 22-25% of national wealth from 2009.

To the extent that the pandemic simultaneously unleashed both significant fiscal stimulus and highly profitable technological innovation, national debt and wealth have moved in tandem. By this yardstick, the U.S. national debt burden looks less onerous.

Summary

We recognize how intensely people feel about the national debt burden. We also understand that there are several intuitive reasons to worry about it. We pass no judgment to either condone or condemn it in this article; we simply examine its likely economic and market impact in the coming years.

We summarize the many reasons why investors hold U.S. government debt and will likely continue to do so on similar terms.

  • High credibility of monetary policies
  • Unparalleled size, safety, quality and depth of the U.S. bond market
  • U.S. dollar as the world’s reserve currency
  • Lack of viable alternatives for domestic and foreign investors
  • Diversification and hedging needs of long duration asset owners
  • Solid governance against fiscal dominance
  • Global glut of savings
  • Disinflation from technology
  • Vibrant economy and formidable military 

We do not expect the national debt burden to create meaningfully higher inflation, higher interest rates or a weaker dollar in the foreseeable future of 3 to 5 years.

We remain vigilant and alert, but we maintain our conviction that the U.S. economy continues to head steadily towards a new equilibrium. We do not anticipate any imminent major shocks in this new economic cycle and bull market.

1Footnote: “Fiscal Deficits and Inflation”, Luis Catao and Marco Terrones, International Monetary Fund

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Excluding intragovernmental debt and debt held by the Fed, the U.S. debt-to-GDP ratio falls from 120% to 77%.

 

The remaining investors have strong incentives to hold U.S. debt for safety, liquidity, diversification and hedging needs.

 

We do not expect the national debt burden to create meaningfully higher inflation, higher interest rates or a weaker dollar in the foreseeable future of 3 to 5 years.

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Sep 4th

Nasdaq Weekly Guest Spotlight: Sandip Bhagat

Whittier Trust Chief Investment Officer, Sandip Bhagat, was recently featured in the Nasdaq Trade Talks Weekly Guest Spotlight. His professional insights and analysis of the current state of the U.S. Market were provided in an Interview format: 

Coming into this year, there was speculation of a potential recession. Why do you think the economy has been so resilient this year?

Fears of an imminent U.S. recession have lingered for several months now; at times, the recession was all but a foregone conclusion for many investors. These worries have valid historical precedent. In the past, a Fed funds rate of 5.4% after 11 rapid rate hikes would have been significantly restrictive in slowing the economy down.

And yet, the U.S. economy has proven to be surprisingly resilient so far. We believe several unusual factors are at play in this post-pandemic recovery. We have long held the view that the U.S. economy is now less rate-sensitive than ever before. After a long period of ultra-easy monetary policy, consumers and corporations alike have locked in low fixed rates well into the future. They are, therefore, more immune to rising rates than they were in the past.

The U.S. consumer has also been supported by a fairly solid jobs market. Despite the recent significant downward revisions in jobs data, monthly jobs growth has still averaged more than 220,000 in the last one year. The rise in the unemployment rate is still below the dreaded 1% threshold and the absolute level of unemployment is still low by historical standards. We note that employers have hoarded labor in the post-pandemic economy to prevent disruptions; we expect this trend to continue.

And finally, we trace the resilience of the U.S. consumer to two unexpected sources of support. Even though incomes and spending have started to deteriorate, the high-end consumer has been buoyed by a significant wealth effect and low debt burdens. The strength in the housing and stock markets has catapulted consumer wealth into its highest historical decile. The prolonged deleveraging that took place after the Global Financial Crisis has also left U.S. households with relatively low debt.

We may yet avoid a recession in the coming months from the following shifts in trends. The pandemic brought about a significant loss of income, which was effectively countered by fiscal policy support. The resulting tailwind of excess savings helped fight off the headwinds of high inflation and interest rates in the last two years. And now, as we deplete those excess savings, low inflation and interest rates are poised to inflect and become tailwinds on the path to a soft landing.

 

Over the course of this year, the markets have been trying to price in rate cuts — oscillating between a single cut and multiple cuts this year. As the Federal Reserve continues to assess economic data, can you speak to the importance of correctly timing the first rate cut? Has the Fed already missed its moment?

The Fed has often committed to a higher-for-longer stance in the last several months. As long as growth was resilient, the Fed had the option to remain patient and keep rates high. Indeed, their policy was largely focused on avoiding the mistakes of the late 1970s. If they were to ease too soon, a potential surge in economic activity might rekindle inflation and send it higher.

Recent economic data, however, is now beginning to reverse. The last couple of months have seen renewed evidence of cooling inflation, a weaker job market and a softer economy. As growth deteriorates and inflation heads lower, the risks of waiting too long now clearly outweigh the benefits of being patient. Several sectors of the economy remain vulnerable to the prolonged impact of higher interest rates. These include the highly leveraged private equity and commercial real estate businesses and the less regulated private credit markets. The balance of risks has now tilted towards growth and away from inflation; the time has come for the start of a new easing cycle.

Our view on future monetary policy has remained largely unchanged through the year even as the market expectations for rate cuts gyrated all over the place. We have felt all along that falling inflation and a slowing economy would allow the Fed to cut rates sooner and more frequently than it believed or the market expected. Along the way, we also formed a view that the new neutral rate for the new post-pandemic economy was 3.1%, which would allow the Fed to make eight to nine rate cuts.

As we did before, we expect three to four rate cuts in 2024, five to six in aggregate by March-April 2025 and all eight to nine by the beginning of 2026. We have believed that the Fed could have started in July; however, a September start doesn’t leave the Fed hopelessly behind with no chance to correct course. It is inconceivable to us that the Fed would hold off any longer. If they do so for any reason, it would be a major policy misstep.

 

What are the market trends you are watching?

Growth is clearly slowing and has yet to bottom out. We expect that it will subside to below-trend levels, but still remain positive. We recognize that it is always hard to achieve a soft landing in the economy. We are intensely focused on any sign of unusual weakness in the jobs market, for instance, unexpected layoffs, early increases in weekly unemployment claims or a sharp drop-off in monthly jobs growth.

Given fairly high valuations, we also recognize that the stock market has a low margin for error. We are confident that high earnings growth expectations will be achieved; however, we are vigilant for any canaries in the coal mine that spell trouble for corporate profits.

Geopolitics and the U.S. elections carry their own set of risks. We are on the lookout for any escalation of geopolitical tensions that threaten global growth or any signs of an election outcome that results in fiscal profligacy without a corresponding growth impetus.

 

Featured in the Nasdaq Trade Talks Weekly Newsletter. Insights and analysis provided by Sandip Bhagat, Chief Investment Officer of Whittier Trust.

The information contained within this feature reflects the data and trends at the time they were written and is not intended to be used as investment advice. For more information, start a conversation with a Whittier Trust advisor today by visiting our contact page.

 

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Jul 18th

Market Insights – Third Quarter 2024

The Big Central Bank Dilemma

The U.S. economy and capital markets continued to surprise investors through the first half of 2024. The year began with high hopes that the rapid disinflation of 2023 would continue in an orderly and uninterrupted manner. This in turn spurred optimism that the Fed would be able to cut rates as early as in March. At that stage, the consensus expectation for monetary policy was 6 to 7 rate cuts in 2024 alone.

These hopes were dashed in the first quarter as inflation readings came in higher than expected. The economy remained unusually resilient as job growth and consumer spending exceeded expectations. In a matter of just
a few months, the timing of rate cuts has changed dramatically. In early July, the Fed’s projections called for just one rate cut in 2024; the market was pricing in two. Not surprisingly, bond yields have also remained higher; most bond market indices generated flat returns in the first half of 2024.

Under normal conditions, such a hawkish pivot in monetary policy might also have derailed stocks, especially at their loftier valuations during most of 2024. Instead, U.S. stocks performed remarkably well in the first half of 2024. The S&P 500 index rose by 15.3%, the Nasdaq 100 index surged 17.5% and the Russell 3000 index gained 13.6%.

Even as monetary policy expectations disappointed, the stock market derived its strength from stellar earnings growth. Most investors were caught flat-footed by their belief that the consensus double-digit earnings growth rates for 2024 and 2025 were simply too high. On the other hand, we had formed the minority view in our 2024 outlook that not only were these earnings levels likely to be achieved, but they could even be exceeded. Stocks handily outperformed bonds in alignment with our tactical positioning.

The resilience in economic activity and inflation at the beginning of the year gave rise to a new theory in support of higher-for-longer interest rates. By historical standards, a Fed funds rate of 5.4% should have been significantly restrictive in slowing the economy down. In fact, many had expected the 11 rate hikes in this tightening cycle to cause a recession by 2024.

A plausible explanation for the muted impact of higher interest rates is that the post-pandemic economy is operating at a higher speed limit. This possibility has several implications. It suggests that the neutral policy rate to keep this economy in equilibrium is also higher. If this were true, then the actual policy rate is not nearly as restrictive as what history would suggest. A higher neutral rate also suggests that eventual Fed easing won’t be as significant as expected. And finally, in this setting, all interest rates would end up higher than expected as well. We explore the possibility of a change in the neutral rate in our analysis.

Recent economic data, however, is now beginning to reverse. The last couple of months have seen renewed evidence of cooling inflation, a weaker job market and a softer economy. By the end of the second quarter, both headline and core inflation had receded to 2.6%, the unemployment rate had risen above 4% and real GDP growth in 2024 was tracking below trend at around 1.5%.

This recent decline in inflation and economic activity poses a difficult dilemma for the Fed. As long as growth was resilient, the Fed had the option to remain patient and keep rates high. Indeed, their policy so far has focused on avoiding the policy mistakes of the late 1970s. If they ease too soon, a potential surge in economic activity might rekindle inflation and send it higher.

However, as growth deteriorates and inflation heads lower, the risks of waiting too long may now outweigh the benefits of being patient. Several sectors of the economy remain vulnerable to the prolonged impact of higher interest rates. These include the highly leveraged private equity and commercial real estate businesses and the less regulated private credit markets. The balance of risks may well tilt towards growth and away from inflation. The Fed is clearly focused on this dynamic; Chairman Powell began his semi-annual July congressional testimony by observing that “reducing policy restraint too late or too little may unduly weaken economic activity and unemployment.”

As a result, the Fed finds itself at a crucial juncture in formulating future monetary policy. In addition to getting the timing of rate cuts right, it also needs to assess the proper neutral rate in this new cycle to calibrate the eventual magnitude of easing.

We focus our article on fully understanding this big central bank dilemma. We offer policy recommendations that may yet allow the Fed to thread the needle and engineer a soft landing. Finally, we juxtapose the Fed’s likely course of action with the divergent easing paths of foreign central banks.

  • Is there a new neutral rate at play? How has it changed? What are its policy implications?
  • When should the Fed make its first rate cut? How many should they do? At what speed?
  • What are the implications of divergent central bank easing policies across regions?

The Neutral Rate

We have previously written about how the U.S. economy is now less rate-sensitive than ever before. Consumers and corporations alike have locked in low fixed rates well into the future; they are more immune to rising rates than they were in the past.

However, the unexpected resilience of the U.S. economy is also starting to spur a new theory about future Fed policy. The key concept in this line of thinking is the so-called neutral interest rate. First, a quick definition. The neutral rate is the equilibrium policy rate that allows an economy to achieve its full potential growth at stable inflation. In other words, it is the steady-state policy rate that is neither restrictive nor accommodative; it is neither expansionary nor contractionary.

While it is intuitive, a major practical limitation of this framework is that the neutral rate is unobservable and, therefore, cannot be measured. It can only be estimated ex-ante; it is eventually validated ex-post by trial and error from actual realized outcomes of growth and inflation.

Many believe that the neutral rate is now permanently higher. They, therefore, contend that there are far fewer rate cuts ahead of us. The more profound implication of this assertion is that higher rates may prevail forever, not just for longer. Market expectations have clearly moved in this direction. We see this in Figure 1.

Figure 1: Market Expects A Higher Neutral Rate Than The Fed Does

Source: Bloomberg, FactSet

The navy line in Figure 1 depicts the market’s estimate of the neutral rate. It is derived from a useful, but less widely followed, measure of future expected risk-free rates. We describe this technical metric as simply as possible and explain how it becomes the market’s proxy for the neutral rate.

The Overnight Index Swap (OIS) is a useful tool to hedge interest rate risk and manage liquidity. For our purposes here, we can think of the OIS rate as the fixed rate for which one is willing to receive a floating rate in exchange. This floating rate is typically tied to an overnight benchmark index such as the Fed Funds Effective Rate. The OIS 5y5y rate shown as the navy line in Figure 1 can be interpreted as the fixed rate for a period of 5 years, starting 5 years from now, at which one would be willing to receive the overnight floating rate in exchange.

In its simplest form, it reflects the market’s projection of the average overnight or risk-free rate over a 5-year period, which begins 5 years from now. Because the OIS 5y5y rate is a proxy for the overnight rate in the longer run, it is the market’s estimate of the neutral policy rate.

The setup for defining the market neutral rate was tedious, but analyzing it is fascinating. Before we do so, here is a quick and far simpler word on the light blue line in Figure 1. It is the Fed’s projection of the long-term or neutral policy rate.

In Figure 1, we see that the market neutral rate has long been anchored by the Fed’s estimate of the neutral rate. Since 2012 in the post-GFC era, the market neutral rate (navy line) has consistently remained below the Fed’s neutral rate (light blue line).

This trend has reversed in the last two years. In recent weeks, the overnight swaps market has been pricing the neutral rate at just below 4% (e.g. it was 3.7% on July 8). On the other hand, the Fed’s long-held estimate of the neutral rate has been 2.5%; the Fed has now revised it up to 2.8% as of June 2024.

The market neutral rate burst above the Fed’s neutral rate in early 2022. We believe the initial 2022 spike in the market neutral rate was driven by expectations of higher inflation. We believe its subsequent rise in the last 12 months has been fueled by expectations of long-term economic resilience.

The Fed’s policy rate is currently at 5.4% and the true neutral rate will determine how low it can go. If the market is correct about the new neutral rate being closer to 4%, cumulative Fed easing will be a lot less than what may have happened in previous regimes of a lower neutral rate.

We offer our own view on where the new neutral rate may emerge in the coming months. We believe it is higher than the Fed’s 2.8% projection, but it is nowhere close to the market’s expectation of around 4%.

As we mentioned at the outset, the neutral rate is unobservable and hard to measure. But we do know that the nominal neutral rate is influenced by inflation. It is also affected by changes in the trend growth rate. We believe each of these factors will be higher in the next cycle and create a new neutral rate of 3.0-3.2%.

We have maintained for a couple of years now that the Fed’s 2% inflation target will likely be elusive. An aging population, along with new potential immigration barriers, will constrain the supply of labor and create a higher floor for wage inflation. We also believe that impediments to global trade in the form of tariffs and a populist mindset of de-globalization will potentially lead to higher inflation. We expect trend PCE inflation to settle at 2.3-2.4%.

We also expect a small increase in trend GDP growth. We have seen a recent rebound in productivity growth; we expect this to become a more secular trend as technology, AI, robotics and automation drive further productivity gains. We also expect the U.S. economy to be modestly more resilient and impervious to higher inflation and interest rates.

We summarize this section with the following observations.

  • We believe a new neutral rate is at play in this economic cycle.

    • It is higher than the Fed’s estimate of 2.8%, but well short of the market’s expectation of 3.7%. We peg it to be around 3.0-3.2%.

  • The market may be mistaken in expecting significantly higher trend inflation or trend GDP growth.

    • Technology remains a powerful disinflationary force.

    • Increases in trend GDP growth will inevitably be bounded by a slowing labor force and only modest productivity gains. The market may be erroneously extrapolating recent economic resilience too aggressively, too far out into the future.

Future FED Policy

Magnitude of Rate Cuts

Our discussion on the likely neutral rate going forward makes it easier to anticipate future Fed policy. The Fed funds rate is currently at 5.4%; we estimate the new neutral rate to be 3.1%. We believe this leaves room for 8 to 9 rate cuts in the next 18 to 24 months. The speed at which the Fed is able to implement these rate cuts will depend on how rapidly inflation and economic growth can cool off.

Timing and Trajectory of Rate Cuts

We preface this discussion with our most startling takeaway. We believe the timing and trajectory of rate cuts, to a large extent, will simply not matter. In many ways, we already have evidence to that effect; they haven’t mattered so far in 2024. Expectations for rate cuts this year have gone down from 6 starting in March to just 2 now by December. And yet, the stock market has been strong; the S&P 500 index was up more than 15% through June.

Our logic for this assessment is simple. As long as the market can anchor to the total magnitude of likely rate cuts based on an understanding of the neutral rate, it will likely look through the timing of the first rate cut and the subsequent speed of the next few.

We, nonetheless, believe that the following sequence of rate cuts may be optimal in balancing both inflation and growth risks.

  • We see sufficiently softer inflation and growth to implement the first rate cut in September and two more by December 2024.

  • We believe the Fed can get to a neutral rate of 3.0- 3.25% before the end of 2026.

  • We hold out the caveat that no Fed action for the next 6 months would be a policy misstep.

Global Central Bank Divergence

Global central banks have been remarkably coordinated and synchronized since the onset of the Covid-19 pandemic in 2020. All of them eased immediately and dramatically to support economic growth during the global lockdowns. Post-pandemic inflation, induced by this flood of liquidity, was also a global phenomenon, which then led to a synchronized global tightening cycle.

As inflation and growth begin to cool down across the world, there is some angst that global monetary policy will not be fully in sync during the upcoming easing cycle. We have already seen this happen. The Fed is still on the sidelines awaiting its first rate cut. In the meantime, the Swiss National Bank has already cut rates twice this year, the European Central Bank (ECB) has eased once, the Bank of England hasn’t moved yet and the Norges Bank has indicated that they won’t ease until 2025.

We believe that the more disjointed global easing cycle is actually justified from a fundamental perspective. These differential easing paths are largely being driven by different growth dynamics across the world. We see this in Figure 2.

Figure 2: 2024 Real GDP Growth Estimates Across Regions

Source: FactSet

Recent GDP growth has been higher in the U.S. than in Europe. It is no surprise, therefore, that the Fed has more flexibility to ease at a slower pace than the ECB does.

We still expect the overall trend towards easing to be consistent across central banks. We believe that the Bank of Japan will be the only major central bank that won’t cut rates by the end of 2025. Many others will begin to do so in 2024. A global easing cycle is about to begin and global short rates are expected to decline by almost 150 basis points over the next 18 months.

We believe stronger growth fundamentals will continue to favor U.S. stocks and the U.S. dollar. As a convenient and desirable byproduct, the strength in the U.S. dollar will continue to be disinflationary and bolster the case for a sustained Fed easing cycle.

Summary

We explored several nuances of the upcoming central bank dilemma. We examined the prospects of a new neutral rate for the U.S. economy, the magnitude and timing of likely Fed rate cuts and the potential for any adverse effects from divergent easing across global central banks.

We summarize our key takeaways below. We believe:

  • There is a new and higher neutral rate of 3.0-3.2% for the U.S. economy in this cycle.
  • While above the Fed’s long-held view of 2.5%, our estimate of the neutral rate is well below market expectations of around 4%.
  • The market is likely overestimating the neutral rate by extrapolating significantly higher trend inflation or trend GDP growth.
  • With the Fed currently at 5.4%, our 3.1% estimate of the neutral rate leaves room for 8 to 9 rate cuts in the near term.
  • Inflation and growth dynamics suggest that the Fed can get to the neutral rate in 18 to 24 months.
  • As long as the markets can anchor to the likelihood of 8-9 rate cuts in aggregate, the actual timing and trajectory of Fed rate cuts will not matter to a large extent.
  • We see enough weakness in inflation and economic growth to advocate the first rate cut in September and two more by December 2024.
  • No Fed action for the next 6 months will likely constitute a policy misstep.
  • Global monetary policy is likely to be less synchronized in the upcoming easing cycle, but not in a materially adverse manner.

We have been increasingly confident that high inflation and interest rates will soon subside. We also remain confident in the earnings outlook. With the tailwinds of accommodative monetary policy and strong earnings growth, we rule out a bear market scenario or even a prolonged correction for U.S. stocks.

Our sustained risk-on positioning in the last two years has worked well. We maintain a similar, but more modest, posture going forward. We continue to exercise prudence in managing client portfolios.

To learn more about our views on the market or to speak with an advisor about our services, visit our Contact Page.

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We believe there is a new and higher neutral rate of 3.0-3.2% for the U.S. economy in this cycle.

 

We believe the market is grossly overestimating the neutral rate at around 4%.

 

With the Fed funds rate at 5.4%, our 3.1% estimate of the neutral rate leaves room for 8 to 9 rate cuts in the next 18 to 24 months.

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Apr 18th

Market Insights – Second Quarter 2024

Watch this video of Sandip Bhagat, our Chief Investment Officer, discussing the latest market insights.

Relative Value... Opportunities or Mirages?

The dramatic melt-up in stock prices during the fourth quarter of 2023 continued into early 2024. Fears of an impending recession continued to recede and economic activity exceeded expectations. Job growth is now down to pre-Covid levels and remains solid. With the Fed firmly on pause after ending rate hikes in 2023, expectations of a pivot to rate cuts took hold during the first quarter.

Stronger-than-expected growth and the potential advent of monetary easing propelled the S&P 500 higher by 10.6% in the first quarter. The Nasdaq 100 rose by 8.5% and the Russell 2000 index of smaller companies gained 5.2%.

The unexpected economic strength was also accompanied by unexpected increases in monthly inflation. Forecasts for the number of Fed rate cuts fluctuated wildly and fell from 7 to 3 by the end of March. Bonds sold off as a result and the 10-year Treasury bond yield rose from 3.9% to 4.2% during the quarter.

Several concerns still linger in investors’ minds. The recent uptick in inflation may halt or reverse the downward trend of disinflation. A higher-for longer restrictive Fed might derail the economy and the stock market. The generally reliable signal from an inverted yield curve is still calling for a recession. And finally, many fear that stock valuations may be dangerously stretched and earnings expectations may be unrealistically lofty.

We addressed these concerns in our 2024 outlook published last quarter. We devote this article to a deeper dive on stock valuations. As investors fret high stock valuations, especially in mega-cap growth companies, they are now searching for more attractive “relative value” opportunities within the global equities universe.

Small cap and international stocks have significantly underperformed in recent years. As a result, their valuations have declined. On a relative basis, their valuation differential to U.S. large cap stocks is now approaching all-time lows.

Figure 1 illustrates the stark valuation differentials between U.S. large (LRG), mid (MID) and small (SML) companies and those in the developed (DEV) and emerging (EM) international markets. We show P/E ratios for each equity index based on 2024 earnings estimates.

Figure 1: P/E Ratios Across Size and Regions

Source: FactSet, US Large: S&P 500 Index, US Mid: S&P 400 Index, US Small: S&P 600 Index, Developed: EFA ETF, Emerging: EEM ETF

A similar valuation dispersion is also observed between value and growth stocks. Value stocks are those that trade at lower P/E multiples; they have underperformed growth stocks by a wide margin in recent years. One of the widely believed stock market anomalies is the propensity of value stocks to outperform growth stocks in the long run.

At this point in the cycle, a big valuation gap is only one of many factors that make small cap, value and international stocks more interesting. Small cap and value stocks usually outperform during a revival of growth after a slowdown. As the prospects of a recession abate, we are conceivably at an inflection point for the resumption of economic growth.

International stocks perform better when the global economy improves and the dollar remains weak or neutral; both of these conditions are likely to prevail in the coming months. And finally, the breadth in the U.S. stock market is remarkably narrow. At the end of March, the top 10 stocks in the S&P 500 index made up an extraordinary 34% of its market capitalization and accounted for 82% of its return in the last 15 months. If breadth expands to more normal levels, value and small cap stocks will most likely benefit.

We recognize these arguments in favor of small cap, value and international stocks. We are even intrigued by their potential to enhance portfolio returns.

But are small cap, value and international stocks truly attractive “mispriced” opportunities, or are they mirages and potential value traps?

We look for important fundamental differences between these equity sub-asset classes which may explain their big valuation differentials. We identify and examine three key differentiators within the equity universe.

  • Sector composition

  • Growth prospects

  • Fundamental quality

We find that there are sufficiently large variations in these fundamental factors to justify the divergence in relative valuations.

We caution, therefore, that “all that glitters may not be gold” in the world of relative valuations. Investors will be better served to look past mirages and avoid value traps where cheap stays cheap or gets even cheaper.

Sector Composition

The U.S. has produced some of the world’s most innovative, successful and dominant companies in recent years. Most of them are either Technology companies or ones whose business model leverages technology in a big way.

On many levels, U.S. large companies exemplify the New Economy where technology lowers costs and increases growth, profits and productivity. Developed international companies lie at the other end of the spectrum. Financials and Industrials dominate the developed international index within a more conventional Old Economy setting.

Figure 2 arrays the sector weights for U.S. large, mid and small companies and those in the developed and emerging international markets.

Figure 2: Sector Weights Across Size and Regions

Source: FactSet, US Large: IVV ETF, US Mid: IJH ETF, US Small: IJR ETF, Developed: EFA ETF, Emerging: EEM ETF

Figure 2 shows larger sector weights within each of the five equity indexes in deeper shades of blue. Two key observations jump out from the heat map of sector weights.

i. The Technology and Communications sectors make up almost 40% of LRG, but are less than 15% of MID, SML and DEV.

ii. Conversely, the Financials and Industrials sectors make up almost 40% of MID, SML and DEV, but are just around 20% of LRG.

At its core, the higher weight in the higher P/E Technology and Communications sectors and the lower weight in the lower P/E Financials and Industrials sectors make LRG more expensive than MID, SML, DEV and EM.

We can adjust for sector weight differentials by equalizing all sector weights to a common level e.g. those seen in LRG. We can then compute sector-adjusted P/E ratios for each of the five equity sub-indexes.

Figure 3 shows sector-adjusted P/E ratios for a more apples-to-apples comparison with equal sector weights.

Figure 3: Sector-Adjusted P/E Ratios across Size and Regions

Source: Same as Figure 1

We can see that the green sector-adjusted P/E ratios show less dispersion than the original blue P/E ratios. The higher valuation of the U.S. large cap index is attributable to the presence of several leading companies whose superior fundamentals command a premium valuation. We believe sector composition is one reason why U.S. large cap stocks are justifiably more expensive.

Growth Prospects

The most general framework for stock valuations is based on discounted cash flow analysis. The price of a stock today is the present value of all future cash flows. In a simplified model with constant parameters, the P/E multiple can be estimated from the dividend payout ratio, the growth rate of cash flows and the required rate of return.

It is both well-documented and intuitive that the higher the growth rate, the higher the P/E multiple. The required rate of return incorporates a “risk premium” which compensates investors for bearing greater risk. The more risky the stock, the higher the required rate of return and the lower the P/E multiple.

We first look at the growth rate of earnings and then the riskiness of companies to understand variations in P/E ratios.

Even though stock valuations are a function of both growth rates and riskiness, a useful heuristic has evolved over the years for those investors who wish to focus primarily on a company’s growth prospects. The P/E to Growth (PEG) ratio divides the stock’s P/E ratio by its growth rate. Although blunt and narrow in scope, this simple adjustment neutralizes the effect of growth rates on P/E ratios. The higher the growth rate, the lower the PEG ratio and the cheaper the stock valuation.

While intuitive, the actual calculation of the PEG ratio is a bit complicated by the difficulty in estimating growth rates. Although historical earnings growth rates can be easily calculated, they may not be a reliable indicator of future growth rates. Analyst earnings estimates are generally available for the next two fiscal years; longer-term future growth rate estimates are either unreliable or simply not available.

Since the PEG ratio is a simplified valuation metric, estimation errors in growth rates become less meaningful. In any case, growth rates tend to be fairly correlated over time and, therefore, do not change abruptly.

We compare the three U.S. equity indexes on PEG ratios in Figure 4. We use available analyst earnings estimates to calculate future intermediate term growth rates. The P/E ratio is still based on 2024 earnings estimates.

Figure 4: PEG Ratios across U.S. Size Indexes

Source: Same as Figure 1

We saw earlier that, based on just P/E ratios, LRG is more expensive than MID, which in turn is more expensive than SML.

Figure 4, however, depicts a different picture after adjusting for growth. The PEG ratios for the three equity size indexes look more uniform; MID actually looks the most expensive based on this measure. This shift in relative value comes from differences in earnings growth rates. LRG has a stellar double-digit earnings growth rate while MID has a growth rate which is only half as high.

The high growth projections for the Magnificent 6 (Nvidia, Microsoft, Apple, Alphabet, Meta and Amazon) highlight the importance of this factor. The Magnificent 6 are expected to grow sales by 13%, earnings by 17% and free cash flow by 22% annualized over the next five years; it makes perfectly good sense for this impressive growth trajectory to drive elevated P/E multiples.

We conclude this section with a simple observation. The higher valuations of U.S. large cap stocks may be more attributable to higher growth rates than to mere speculation.

Finally, we take a look at the diffuse and amorphous concept of fundamental quality to further understand differences in P/E ratios.

Fundamental Quality

We have so far discussed size, value and growth; they are all fundamental drivers of stock valuations and returns. The common theme across these three factors is that they can be defined easily and measured fairly precisely. Size is simply market capitalization, value is the ratio of price to earnings, sales, free cash flow or book value and growth measures the annualized change in earnings, sales or free cash flow.

Unlike these clear and homogenous factors, the concept of quality tends to be more nebulous and heterogeneous. Some investors may associate high quality with high profitability; they would focus on return on assets, return on equity and return on invested capital. Others may look for more efficient capital allocation in the form of reduced debt, higher dividends and more share buybacks.

Yet others would approach quality from the perspective of how risky a company is. In this instance, higher quality would imply better balance sheets and stronger income statements derived from superior business models. Attributes that capture high quality in this vein may include low earnings variability, low volatility of operating margins, low financial or operating leverage and low accounting accruals.

The heterogeneity of high-quality companies and their myriad risk exposures make it difficult to quantify the impact of the quality factor on valuations. Nonetheless, it is reasonable to infer that high quality embodies stability, durability and resilience and should lead to higher valuations.

For the scope of this article, we stick with a qualitative discussion of the quality theme. We look at return on invested capital (ROIC) as a broad measure of profitability. Companies invest capital in people and assets to earn a rate of return. In order to be accretive to economic value, this return must exceed the firm’s weighted average cost of debt and equity capital.

The return on invested capital is a powerful profitability metric that affects both current valuation and future earnings and returns. Large increases in ROIC will enhance firm value and generate higher returns. A high level of current ROIC captures past value creation and is reflected in higher valuations.

We examine ROIC and other measures of profitability for our five equity indexes. We also look at the relative volatility of earnings and margins. Here are some generalized observations.

a. The return on invested capital for U.S. large companies is higher than it is for any of the other size or regional indexes. In fact, the ROIC for LRG is almost double the ROIC for SML. The same is true for return on equity.

b. Return on invested capital for LRG now exceeds 10% and its return on equity is greater than 20%. These are unprecedented levels of profitability for any stock market index. We believe these levels and trends are sustainable for U.S. large companies.

c. At the same time, the relative standard deviation for ROIC as a risk measure is almost twice as high for MID and SML as it is for LRG. The relative standard deviation for operating margins follows a similar pattern.

U.S. large cap stocks have higher financial and operational quality. They are fundamentally more profitable and less risky than their small cap and international counterparts. We believe a big portion of their premium valuation comes from the positive quality differential in their favor.

Summary

Investors are mindful of high stock valuations overall and the potential for a broadening of this stock market rally beyond mega-cap growth companies. Against this backdrop, they are focused intently on uncovering relative value within equity sub-asset classes such as small cap, value, international developed and emerging market stocks.

We assess whether the big valuation differential between U.S. large cap stocks and the other equity sub-indexes is justified fundamentally or simply a profitable mispricing opportunity. We look at sector composition, growth prospects and fundamental quality as potential drivers of valuation differentials.

U.S. large cap stocks have a greater representation of highly profitable, faster growing and higher P/E Technology and Communications companies. They also encompass higher fundamental quality as defined by a myriad of factors.

In large part, small cap, value and foreign stocks are cheaper for a good reason. They are more heavily invested in less attractive companies and industries which exhibit lower profitability, slower growth, lower quality and greater fundamental risk in earnings and margins.

We believe that adjusting for sector composition, growth rates and fundamental quality eliminates most of the valuation differences across equity sub-indexes. It may yet make sense to look beyond U.S. large cap stocks. We believe the reason to do so would be for the macro considerations of a revival in growth and risk appetite; it is less likely because of fundamental mispricing at a micro level.

We are more comfortable that the coast is becoming clearer for risk assets. Since economic growth is stronger than expected, we do not expect a higher-for-longer interest rate backdrop to derail stocks. At the same time, we remain vigilant for unforeseen and unexpected risks to our outlook.

To learn more about our views on the market or to speak with an advisor about our services, visit our Contact Page.

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 Sector composition is one key reason why U.S. large cap stocks are justifiably more expensive.

 

The higher valuations of U.S. large cap stocks may be more attributable to higher growth rates than to mere speculation.

 

U.S. large cap companies also have higher financial and operational quality — they are more profitable and less risky.

From Investments to Family Office to Trustee Services and more, we are your single-source solution.

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Jan 22nd

Market Insights – First Quarter 2024

Watch this video of Sandip Bhagat, our Chief Investment Officer, discussing the latest market insights.

Slow... But Steady

The last four years have felt like one endless blur of unprecedented events ... all unfolding in rapid succession. And 2023 was no different; it was perhaps even more extraordinary than the previous three years.

The surprises in 2023 were numerous. Much like the spectacular spike in inflation, the pace of disinflation in 2023 was remarkably rapid as well. Even as long-term interest rates rose unexpectedly in the second half, the U.S. economy remained remarkably resilient. As a result, U.S. large cap stocks performed magnificently in 2023 as the S&P 500 index gained 26.3%.

At the dawn of a new year, we reflect on our 2023 predictions with fond satisfaction.

We had practically ruled out the possibility of a deep and protracted recession in 2023. Our base case for the economy last year was a soft landing – with a short and shallow recession as the worst case scenario.

Our optimism on economic growth was based on what we believed were under-appreciated tailwinds from the post-pandemic stimulus. We perceived that the residual effects of prior monetary and fiscal stimulus were likely to offset the headwinds of higher inflation and higher interest rates.

Our view on inflation at the beginning of 2023 was relatively benign. We felt that fears of sticky and stubborn inflation were overblown. We predicted that core measures of inflation would be closer to 3% by the end of 2023. As a result, we also felt that the Fed would end up with more flexibility on future rate cuts than it believed or the market expected.

And finally, our constructive views were also reflected in our stock market outlook for 2023. We had ruled out the possibility of retesting prior lows in stock prices or making new ones. Our expectation for solid double-digit gains was based on the view that earnings growth would bottom out by mid-2023 and then rise subsequently.

We are pleased that these views were validated by what transpired in 2023. We were misguided, however, in our forecast that bonds would provide a decent term premium. Bonds were in negative territory for most of 2023 and finally eked out positive returns in the midst of high volatility.

Today, the odds of a recession have receded significantly and a soft landing is now the consensus view. We begin to develop our 2024 outlook from this vantage point.

Drivers Of The 2024 Outlook

Even as market optimism turned higher at the end of 2023, a number of concerns still linger in the minds of investors. Here, in no particular order, we walk through a long list of worries that investors may yet harbor.

  • An inverted yield curve has been a reliable predictor of recessions in the past. At this point, the yield curve has been inverted for more than 300 days.
  • Leading economic indicators have declined steadily for almost a year and a half.
  • Bank deposit growth and money supply growth are both in negative territory and close to levels seen in the 1930s.
  • The adverse economic effects of Fed tightening tend to be felt on a lagged basis – many fear the worst is yet to come.
  • The last mile of disinflation may prove difficult or even elusive.
  • The Fed may make a mistake by keeping policy too restrictive and interest rates too high for too long.
  • And finally, investors fret that stock valuations and earnings growth expectations are too high.

We address these concerns in forming our 2024 outlook by taking a closer look at inflation, growth, interest rates, profit margins, stock valuations and the earnings outlook.

Our headline summary is more constructive than the concerns highlighted above.

a. We believe GDP growth will continue to slow but only to below-trend levels; it is unlikely to turn negative.

b. We assign low odds to a moderate or deep recession and believe that growth may surprise to the upside.

c. Inflation will continue to recede but may normalize above the Fed’s 2% target.

d. Earnings may exceed expectations due to a potential improvement in profit margins.

e. We expect that both stocks and bonds will deliver modestly positive returns.

We validate our outlook with a closer look at four key fundamental drivers: inflation, interest rates, growth and earnings.

Inflation

We have made significant progress with disinflation in recent months ... probably more than many had expected.

And yet, two concerns remain on the inflation front.

  1. Will any unusual economic strength rekindle inflation and send it higher?

  2. Will the last leg of disinflation simply be too stubborn and difficult to achieve?

Inflation is unlikely to revert meaningfully higher for a number of reasons.

One, the sticky shelter component of inflation has just turned the corner and will continue to head predictably lower.

Two, the job market has long peaked in strength and will continue to weaken further. This will exert downward pressure on wage inflation.

And finally, we believe that the recent gains in productivity will continue into 2024.

Pandemic-related disruptions caused productivity to plummet. Employers had to scramble to train new workers who initially were not as productive as their predecessors. As the labor force normalizes, a pickup in productivity gains will ease overall inflation.

And this brings us to our second question: Can inflation subside all the way down to the Fed’s 2% target? And if so, how soon?

Our view here is a bit mixed. We believe inflation will continue its orderly decline in 2024. We expect headline and core inflation to soon head below 3%. However, we suspect that inflation may eventually come to rest below 2.5%, but above the Fed’s 2% target.

A couple of factors inform our view here. We expect growth to remain modestly resilient in 2024. We also expect an ageing population to constrain labor supply and put a higher floor on wage inflation.

Finally, we believe that even inflation of almost 2.5% will still be favorable for stocks and bonds.

Interest Rates

Our positive outlook on inflation makes it easy to develop a view on interest rates. We begin with the Fed and then move to long-term interest rates.

The Fed’s policy rate of 5.4% is already far above inflation which is averaging 3-3.5% on a year-over- year basis. The implied short-term real interest rate, which is simply the spread between policy rates and inflation, of 2-2.5% is already quite restrictive. We rule out any further rate hikes; the Fed is done with tightening.

Figure 1 shows just how restrictive Fed policy has become in recent months.

Source:  FactSet

The blue bars in Figure 1 show 12-month core PCE inflation (PCE stands for Personal Consumption Expenditures). Core PCE is the Fed’s preferred inflation gauge.

We can see how core PCE has fallen steadily in 2023 and is projected by the Fed itself to fall further in 2024.

The green line shows the Fed funds rate which is now higher than inflation by well over 2%. Under normal conditions, the Fed funds rate exceeds inflation by about 0.5%. A real short-term interest rate in excess of 2% is clearly restrictive. If inflation falls by another 1% or so in 2024, the Fed will have the flexibility to cut rates several times.

We expect five to seven rate cuts in 2024 beginning in March or May.

We are cognizant of the possibility that the Fed begins later and implements fewer rate cuts. Such a policy misstep would undoubtedly magnify the depth of the slowdown. But it is still unlikely to be a devastating event for the markets; we reckon the economy is just less rate-sensitive now than before.

Our view on the 10-year Treasury bond yield is derived from our outlook on inflation. We expect inflation to normalize below 2.5% in 2024. We expect a positively sloped yield curve to evolve over time. We also predict positive real rates and a positive term premium in the future.

We coalesce these thoughts to form our forecast for the 10-year Treasury bond yield in the range of 3.7-3.9%.

Growth Prospects

A long list of reliable indicators argue for a traditional, perhaps even a deep, recession in 2024 – just like they did in 2023.

In 2023, our counter-view on the topic was based on the under-appreciated tailwinds of massive prior stimulus from 2020 to 2022. A simple example of this support was the excess savings that consumers had accumulated from the post-pandemic fiscal stimulus. One of the legacies of ultra-low interest rates from that period was that consumer and corporate debt got locked in at low fixed rates.

For 2024, we argue against a modest or deep recession along different lines.

The biggest concerns right now revolve around the consumer and the job market. Many fear that it is only a matter of time before the consumer wilts under the pressure of high interest rates. And as the job market begins to soften, the skeptics fear it will eventually lead to the dreaded 1% increase in the unemployment rate.

We tend to disagree with both narratives.

We have pointed out extensively that the U.S. economy is less sensitive to interest rates now than it has been in the past. The consumer may, therefore, be more insulated from the lagged effects of Fed tightening. We also note that discretionary spending for lower income households is more affected by rent, food and energy costs than it is by interest rates.

And as resilient as the job market has been, we find it hard to believe that the unemployment rate will go above 4.5%. So far, employers have hoarded labor to prevent disruptions; we expect this trend to continue.

We conclude with our key under-appreciated takeaway on the growth front. Lower inflation in 2024 will help support consumer spending and offset the lagged impact of higher interest rates.

Earnings Outlook

Stocks have sold off in the early going so far in 2024. There is now a growing sense of foreboding that both earnings expectations and stock valuations may be too high. It is feared that these, in turn, may lead to mediocre stock market returns in 2024.

S&P 500 earnings for 2024 are projected to grow by about 11%.

Investors perceive risk in this 11% earnings growth estimate for 2024 because of a well-documented historical pattern. Analysts chronically overestimate earnings at the beginning of a year. As the year progresses, those estimates come down predictably by 4 to 8 percentage points.

We are aware and respectful of that trend. However, we identify a couple of potential positive offsets to that downtrend.

Profit margins have been compressing for the last year and a half because of high inflation. Higher input costs for labor and raw materials generally cause margins to decline.

We see this downtrend in Figure 2.

Source: FactSet

Inflation in 2024 will be a lot lower than it was in 2022 and 2023. We expect that a lower cost of goods sold will improve profit margins and provide some upside to earnings. The decline in interest rates should also help profit margins to some extent.

We also note that earnings have been unusually erratic in the last ten years or so. A crisis in commodities and currencies roiled markets in 2016. The Trump tax cuts abruptly boosted earnings in 2018. The pandemic wreaked havoc in 2020 and then war and excessive stimulus unleashed inflation and curtailed profits in 2022 and 2023. We see this wayward trajectory of earnings in Figure 3.

Source:  FactSet

S&P 500 earnings per share for 2023 will likely come in within a range of 219-220. This is well below the trend level of earnings assuming historical growth rates from 2015 onwards. We notice that even the 244 level of earnings forecasted for 2024 remains below the trend line of normalized earnings. As macro headwinds diminish, we are optimistic that the consensus earnings forecast for 2024 will be met or exceeded.

And finally, a word on stock valuations.

The forward P/E ratio for the S&P 500 currently stands at about 19 times. While it is high by historical standards, it is not so different from recent averages. We believe that the stock market is gradually evolving to a structurally higher normalized P/E than its long- term historical average.

The S&P 500 index in aggregate produces free cash flow margins of about 10% and return on equity of around 20%. These are unprecedented levels of high profitability. We believe these are sustainable levels of profitability for large U.S. companies going forward and, therefore, supportive of higher stock valuations.

We are more tolerant of today’s P/E ratios than most investors.

2024 Outlook

We are aware of the long list of indicators that still argue in favor of a recession. These include the continued inversion of the yield curve, steadily declining leading economic indicators and negative growth in bank deposits.

  1. We acknowledge these factors will continue to slow down growth. Our base case calls for below- trend, but still positive, GDP growth. Our worst case scenario is a short and shallow recession. We assign low odds to a traditional or deep recession.

  2. Lower inflation in 2024 will support consumer spending and offset any lagged effects of higher interest rates. Even as the job market softens, the unemployment rate will remain well below 4.5%.

  3. We do not anticipate any meaningful uptick in inflation from here on. Inflation should continue to decline in a fairly orderly manner to below 2.5%. The impetus for lower inflation in 2024 will come from declining shelter inflation, a weaker job market and continued productivity gains.

  4. It may be difficult to achieve the Fed’s 2% inflation goal in the next couple of years. A higher floor on inflation may emerge from a couple of factors: modestly resilient growth in the near term and an ageing population which limits labor supply in the long run.

  5. With the significant progress on disinflation, the Fed is already quite restrictive in its policy. If inflation falls further in 2024, the Fed will have the flexibility to cut rates several times. We expect five to seven rate cuts in 2024 beginning in March or May. We expect the 10-year Treasury bond yield to normalize just below 4%.

    6. We are more comfortable with earnings estimates and stock valuations than the current consensus view. We believe that lower inflation in 2024 will lead to higher profit margins overall. We also believe that higher P/E ratios are fundamentally supported by the higher profitability of companies within the S&P 500 index.

  6. We do not expect political or geopolitical risks to materially affect stock or bond returns.

  7. For calendar year 2024, we forecast mid-single digit bond returns and high single digit stock returns. We see more upside for stocks than we do for bonds. We remain bullish on stocks but at a lower portfolio weight than in prior years.

We are confident that the battle against inflation has been largely won and will soon come to an end. Investor focus is now squarely on growth, which becomes the key determinant of investment performance.

We realize that a lot of uncertainty still persists about the future trajectory of economic and earnings growth. As a result, we emphasize high quality and sustainable competitive advantages in our investment decisions. After a highly rewarding year, we will exercise even more caution and care in client portfolios.

 

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We believe GDP growth will continue to slow but only to below-trend levels; it is unlikely to turn negative.

 

Inflation will continue to recede but may normalize above the Fed’s 2% target.

 

Earnings may exceed expectations due to a potential improvement in profit margins.

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Oct 17th

Market Insights – Fourth Quarter 2023

Rising Interest Rates

The speed and magnitude of economic developments in recent years have been nothing short of remarkable.  The last four years have felt like one endless sequence of unprecedented events in rapid succession.

2023 has been almost as extraordinary as the previous three years.  Much like the spectacular spike in inflation, the pace of disinflation in 2023 has been remarkably rapid as well.  Headline CPI inflation has fallen from above 9% to around 3% in the last five quarters.  Core PCE inflation is now below 4% year-over-year and has grown at an annualized pace of just about 2% in the last three months.  

The U.S. economy has also been remarkably resilient in the third quarter of 2023.  As a result, the odds of a recession have receded steadily in the minds of investors.  On one hand, this combination of lower-than-expected inflation and higher-than-expected growth should have given investors reason to celebrate.  After all, it could have been viewed as a successful milestone in the journey to a soft landing.

However, these hopes are now at risk from perhaps the most remarkable outcome of the third quarter – a sharp rise in long-term interest rates.  A swift increase of more than 1% in the 10-year Treasury bond yield was the primary driver of the stock and bond market selloff in September.

The recent market turbulence has ignited renewed fears about the future trajectories for growth and inflation.  The potential outcomes range from stagflation in the near term to a deeper eventual recession from the adverse impact of higher interest rates.  

We focus our analysis here on answering two key questions.  

  • Why have long-term rates risen so sharply?  
  • And what are the likely implications of such an increase? 

Drivers of Higher Rates

Just as it appeared that we may be reaching the end of this tightening cycle, the Fed emphatically signaled a “higher for longer” stance at its September meeting.  The hawkish Fed announcement on the monetary front coincided with a political disagreement on the level of government spending and fueled another upward spiral in long-term interest rates.

In its simplest fundamental framework, changes in long-term interest rates are influenced by three factors.

  1. Changes in inflation expectations
  2. Changes in growth expectations
  3. Changes in the “term risk premium” or compensation for bearing interest rate risk 

We take a closer look at each of these factors.  Along the way, we also identify some peripheral influences that may be exerting upward pressure on long rates.

Probably Not Driven by Inflation

We have made significant progress with disinflation in recent months … probably more than many had expected.  And yet the concern remains that inflation is still above 2% and any unusual economic strength will simply stoke it further, send rates higher and trigger an even deeper recession down the line.

We believe that inflation is firmly on its way down and remain optimistic that the recent trend of disinflation will continue.  We summarize our inflation outlook in Figure 1 below.

Source:  Factset

The dark blue line in Figure 1 shows headline CPI inflation.  It peaked at 9.1% in June 2022 and has since declined to 3.7% in August.  By now, it looks like we are well past the peak in inflation.   

The small spike in headline inflation at the far right is attributable to the recent rise in oil prices.  Barring a major escalation of geopolitical risks, we believe there is limited upside to oil prices after these gains.  Besides, energy costs are notoriously volatile and core inflation, which excludes food and energy, remains in steady decline.

The decline in core inflation is particularly encouraging because it is known to be sticky.  Wages are a key component of core inflation.  The green line in Figure 1 shows growth in average hourly earnings as a proxy for wage inflation.

Wage inflation peaked almost a year and a half ago at around 6%.  It has since fallen steadily to just above 4%.  It is interesting that we have achieved this disinflation without any major disruption in the labor market.  

The light blue bars in Figure 1 show that the unemployment rate was steady between 3.4% and 3.8% as wage inflation declined from 6% to 4%.  This leads us to believe that we have not yet seen meaningful demand destruction.  Instead, we suspect that the pandemic created transitory supply side shocks which have since abated to provide meaningful disinflationary relief.

We conclude from Figure 1 that recent disinflationary trends remain intact and will likely persist as the economy cools further in response to higher interest rates.

We have further evidence to support our conclusion that inflation is not the primary driver of higher long-term interest rates.  Figure 2 shows 10-year Treasury yields and 10-year breakeven inflation expectations priced into inflation-protected bonds.

Source: Factset

The dark blue line in Figure 2 shows the dramatic increase in 10-year Treasury yields in recent weeks.  The 10-year breakeven inflation rate in light blue has remained virtually unchanged over that period.  Investors are clearly not pushing long-term interest rates higher because of higher inflation expectations over the next 10 years.

Likely Not Triggered by Growth Either

Since inflation expectations have remained practically unchanged, the rise in nominal interest rates has essentially led to an increase in real (nominal minus inflation) interest rates.

A typical driver of changes in real interest rates tends to be a change in growth expectations.  At first glance, it is tempting to attribute higher long-term interest rates to higher long-term growth expectations.  After all, we did allude earlier to unexpected recent resilience in economic activity.  

But we rule out this possibility on further reflection.  Yes, the odds of a recession in the near term may have receded.  But it is unlikely that a burst of economic strength in the short run could materially increase long-term growth rates over the next 10, 20 and 30 years.

In fact, we know that the two drivers of long-term real GDP growth are labor force growth and productivity growth.  We show how these building blocks have historically contributed to the potential growth rate of the U.S. economy in Figure 3.

Whittier Trust - Potential Real GDP Growth Rates

Source:  Congressional Budget Office 1950-2022, Whittier Projections 2023-2033

We can think of the potential growth rate of an economy as the natural speed limit at which it can operate without unleashing inflation.  

We see in Figure 3 that the potential GDP growth rate of the U.S. economy has slowed steadily over the last 70 years.  Productivity gains held steady for most of that period before falling in the Global Financial Crisis and the Covid pandemic.

However, an aging population has dramatically altered the growth dynamics of the U.S. economy.  As the baby boomers age, the labor force participation rate has declined steadily in recent years.  Labor force growth has slowed down from around 2% in the first 40 years of this period to barely 0.5% in the last 15 years. 

We project that this trend will continue well into the future.  Demographic shifts are slow to unfold and predictable in their evolution.

We see nothing to suggest that the long-term potential GDP growth rate of the U.S. economy has risen in recent months.  It is unlikely that changes in growth expectations can explain the rise in long-term interest rates.  

We recognize that a dramatic shift in immigration policy or a significant increase in AI-induced productivity growth could change this dynamic.  But we see these as more speculative possibilities at the moment.

Conceivably Related to Policy Risk

We finally assess if investors are pricing in a greater level of risk and uncertainty in their outlook for bonds.  In that scenario, investors would demand greater compensation for bearing the risk of investing in long-term bonds in the form of lower prices and higher yields.

Let’s look separately at the risk of misguided central bank monetary policies and imprudent fiscal spending policies from the central government.

We know the Fed has signaled a higher-for-longer stance on short-term interest rates.  The big risk with this approach is that monetary policy may become too restrictive at some point and throw the economy into a recession.  However, such an outcome would lead to declining, not rising, long-term interest rates. 

While monetary policy risk doesn’t inform our current inquiry into rising long rates, we will come back to it in the next section on the implications of higher short-term and long-term interest rates.

After ruling out inflation, growth and monetary policy risks as drivers of higher long-term rates, we may finally have a plausible candidate in the form of higher fiscal policy risk.  

Federal debt has risen sharply as a result of the fiscal stimulus provided during the pandemic; it now stands at $33 trillion and 120% of GDP.  While the magnitude of this debt burden has been known for some time now and is hardly new information, investors may finally be getting concerned about the lack of both fiscal discipline and bipartisan alignment in Washington.  

The Congressional Budget Office now projects the public debt to GDP ratio to reach 200% in the next 30 years.  And the political dysfunction in recent months has ranged from a protracted battle on the debt ceiling to a near-shutdown of the government and a subsequent change in House leadership from a revolt by Republican hardliners.  In the meantime, interest rate volatility has picked up and bonds are now poised to generate negative total returns for an unprecedented third consecutive year.  

It is quite possible that investors are repricing long-term bonds to higher yields in response to greater fiscal policy risk and higher asset class risk.

We also suspect that a couple of other factors may be accentuating the sharp rise in bond yields.  After the debt ceiling crisis in May, Treasury issuance has been higher while Japan and China have reduced their purchases of U.S. Treasury bonds.  

The imbalance arising from more supply and less demand may be creating a liquidity-driven price dislocation in the near term.  And we would not rule out a speculative momentum-driven trend that continues to push prices lower and yields higher.

We summarize this section by attributing the recent rise in interest rates to a repricing of fiscal policy and asset class risks.  In the process, we observe that neither long-term inflation expectations nor growth expectations have changed materially.  

We also believe that short-term liquidity effects and speculation may have pushed interest rates beyond fair values based on the fundamental repricing of risks.  We believe that the 10-year and 30-year Treasury bond yields are likely to normalize closer to 4% than above 5% in the coming months.

We next look at the likely impact of rising rates on the economy and markets.

Implications of Higher Rates

Rapid monetary tightening has led to financial accidents in the past.  We almost got one in March in the form of a banking crisis.  However, prompt and powerful policy actions contained the damage to the collapse of just a handful of regional banks.

The prospect of higher rates for longer is now raising concerns about what might break next.  As these worries mount, investors are starting to bring the hard landing scenario back to the fore again.  

Higher Recession Odds?

The ability of the U.S. economy to first withstand high inflation and now higher interest rates has caught many by surprise.  Based on history, many conventional indicators have already been predicting the onset of a recession by now.  

The more notable ones include an inverted yield curve for over a year, a continuous decline in the Leading Economic Indicators index for almost a year and a half and a collapse in year-over-year money supply growth to levels last seen in the Great Depression.

Instead, the job market and the consumer have remained resilient.  Does the solid job market run the risk of creating an economy that is still too hot and, therefore, poised to unleash inflation at any moment?  We don’t believe so.  

Job growth has now declined steadily for several months from its torrid stimulus-induced pace.  And the consumer and the economy will continue to face future headwinds from the eventual lagged effects of higher interest rates, the depletion of excess savings from the Covid stimulus and the resumption of student loan repayments.

We also show how higher interest rates may affect consumer spending differently than they have in the past.

Mortgages and auto loans are two of the bigger components of household debt.  Consumers locked in low rates on those debt obligations during the long periods of easy money between 2008 and 2021.  We see that clearly in Figure 4.

Source: WSJ, Moody’s Analytics

Only 11% of outstanding household debt in 2023 carries rates that fluctuate with benchmark interest rates.  By contrast, this proportion was above 35% in the late 1980s.  

Although floating rates on credit card loans are rising with the Fed’s tightening, a significant portion of consumer debt is fixed at low rates from a few years ago.  This has allowed many households to continue spending despite the rise in interest rates.

Also, households are still paying less than 10% of their disposable income to stay current on their debts even with higher rates.  This is well below the high from 2008 and is also lower than the post-crisis average.

We believe the prevalence of fixed-rate debt on consumer balance sheets has made the U.S. economy less rate-sensitive.  

Here are a few observations which highlight a similar effect on corporate balance sheets and income statements.

  • Corporations also refinanced a lot of their debt to longer maturities at lower fixed rates.  Almost half of S&P 500 debt is set to mature after 2030.
  • The notional share of investment grade and high yield debt maturing within two years is around 15%, well below its 25% share in 2008.
  • Despite the sharp increase in Fed funds rates, net interest payments for companies in 2023 are actually lower than they were a year ago.

We acknowledge that the lagged effects of higher rates will continue to slow growth.  We do not, however, expect a significant recession in 2024.

Policy and Portfolio Considerations

The Fed funds rate is currently at 5.4%.  The latest Fed projections point to one more rate hike in 2023 and two rate cuts in 2024.  With policy rates projected to remain above 5% for over a year, we understand investor concerns about a potential Fed misstep.  

As inflation falls below 4%, short-term interest rates are becoming restrictive by historical standards.  Any continued decline in inflation will make current monetary policy even more restrictive.  The resulting increase in real rates could trigger a recession.  

While we recognize this risk, we feel that a sufficiently responsive Fed will manage to avoid it.  To the extent that the next recession will be induced by Fed policy, we believe the Fed will also have the ability to manage it before it becomes entrenched. 

We believe that the growing evidence of a slowing economy and declining inflation gives the Fed more flexibility than what can be inferred from their forecasts.  We discuss potential Fed actions across different economic outcomes.

Let’s assume that growth begins to slow materially to risk a recession.  In this setting, inflation is also likely to come down.  Now the Fed no longer needs to be restrictive because the inflation war has been won; it can begin to cut rates.  However, if inflation doesn’t subside to desired levels, it may well be on the heels of a stronger economy in which case a recession becomes moot.

We do not expect to see either of the two scenarios that invalidates our outlook – high inflation in the midst of a recession or a stubborn Fed which keeps rates high going into a recession.

At a portfolio level, we remain constructive on both the stock and bond markets.  Long-term bond yields have already risen significantly.  The 10-year bond yield reached a high of 4.88% in the first week of October; we believe it may have more room to fall from this level than to rise further.  Bonds have clearly repriced to offer more compensation to investors.

The rise in interest rates has also taken a toll on stocks.  By the first week of October, stocks had fallen by almost -8% from their July highs.  On one hand, the rise in interest rates reduces stock valuations.  On the other hand, lower odds of a recession improve cash flows.  At current valuations, we believe stocks still offer above-average returns relative to bonds over the next year.  

Summary

We set out to understand the drivers and implications of the recent rise in long-term interest rates.  Here is a summary of our key observations.

  • We rule out higher inflation, growth and monetary risk as the drivers behind the recent rise in long-term interest rates.
  • Instead, we attribute the recent rate increases to a higher risk premium (i.e. risk compensation), reduced liquidity and greater speculation.
  • Monetary policy is getting restrictive and, even without any more rate hikes, will become more so if we see less inflation.
  • Policymakers will eventually avoid the risk of major financial accidents from remaining overly restrictive.
  • Both stocks and bonds are attractive after repricing lower in recent weeks.

We recognize that the coast is far from clear and a lot of uncertainty still persists.  We respect the need for greater vigilance in portfolio management during these turbulent times.  We continue to exercise caution and care in client portfolios.

 

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The recent rise in long-term interest rates has renewed fears about the future trajectories for growth and inflation.

 

Long-term bonds are likely pricing in greater fiscal policy risk and higher asset class risk.

 

Both stocks and bonds are attractive after repricing lower in recent weeks.

From Investments to Family Office to Trustee Services and more, we are your single-source solution.

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