October 9, 2023Scroll down
The CIO’s Take:
Like many investors last week, we were holding our breath for Friday’s BLS report on September employment, seeking some evidence that could give rise to a shift one way or the other in last month’s FOMC dot plot, which suggested a central bank intent on squashing inflation, even at the risk of causing investors some pain before the easing starts. We sure got our confirmation, in the form of a staggering beat on nonfarm payrolls, which in our view marginally increases the chances for another Fed hike and pushes out the timeline for rate cuts to at least late-2024 (in the absence of something breaking). With the equity risk premium hitting zero for the first time since 2002, and a range of potential pitfalls—not least, the obviously serious dysfunction in a government charged with navigating very challenging fiscal conditions—we remain convinced the best position to take now is one of caution, underweight stocks and overweight low-duration US Treasuries, with plenty of dry powder and an eye toward exploiting opportunities created by potential dislocations.
Payrolls massively surprise to the upside
Markets eagerly awaited last Friday’s BLS report on US employment for the month of September, widely acknowledged as a key input to the Fed’s “data dependent” approach, which puts the US central bank on the lookout for signals that might confirm whether the economy is strong enough to withstand a higher-for-longer policy messaged at last month’s FOMC. Friday’s report left little doubt on the labor market’s resilience, showing an increase in nonfarm payrolls of 336,000 jobs: almost double the consensus estimate for 170,000 new jobs, and substantially higher than the 237,000 jobs added the month prior. The unemployment rate remained stable at 3.8%, versus expectations for a slight decline to 3.7%. Job gains in September were broad-based, with employers ranging from restaurants and bars to retailers and manufacturers adding positions. The release also detailed upward revisions to previously reported figures in July and August.
Bonds sell off, stocks set sights on soft landing
Bonds reacted to the report as one might expect, with fears labor market strength could motivate the Fed to err on the side of keeping rates elevated for some time—and maybe even hike again—pushing Treasury yields higher. By Sunday traders tracked by the CME Group were likewise pricing in a 43% probability of additional hikes in 2023, up from around 35% a week prior. Stocks had a different reaction, initially selling off on the BLS report, but then moving back into the black by the close of trading, as the S&P 500 ended up 1.2% for the day, breaking a four-week losing streak for US stocks. Equity investors looked past the Fed policy implications of a strong labor market, focused on what brisk job gains say about the odds of a soft landing. There was also a potential bright spot in Friday’s report on the inflation front: wage growth was slightly softer than expected, coming in at 0.2% month-over-month, versus a consensus estimate of 0.3% growth.
High yields squeeze equity risk premium
Whatever the rationale for stocks’ sanguine response to the hot job market report, a shift back to rally mode for equities at the same time Treasury yields are hitting new highs puts major pressure on a quantity we have often discussed over the last year: the equity risk premium (ERP), measuring the difference between stocks’ earnings yield and the yield available on 10-year government notes. A higher ERP suggests stock market investors earn higher returns to compensate them for bearing greater risk, and the bigger that number, the greater the attractiveness of stocks relative to bonds. Surging stocks—which push the earnings yield down—along with rapidly rising long-term rates have compressed the ERP to zero (see below), its lowest level in over two decades, and a level at which it’s much harder to justify taking equity risk.
While we don’t view the ERP as a great short-term timing signal, it’s hard to argue stocks are a bargain under such conditions, and investors might reasonably wonder why they ought to hold any risk when bonds yield close to 5%. Indeed, the chart above goes a long way toward explaining why, in the face of so many looming risks, we are substantially underweight equities, preferring active, opportunistic stock picks over broad exposure to risk assets offering historically low implied upside.
US government narrowly averts a shutdown
With the equity risk premium at zero, someone not watching cable news and otherwise out of touch with US politics might be forgiven for imagining the American government was running smoothly in service of its people and the economy. Of course, we all know that’s not the case, and events of the last few weeks make it clear conditions in Washington can always get messier. Just over a week ago, traders were bracing for the impact of a potential government shutdown. An eleventh-hour resolution to keep the government open for an additional six weeks kicked the can on that issue down the road a bit, though we expect more volatility as the November 17th deadline to readdress this issue approaches. What would happen if the government fails to get its act together in the next month and a half and lawmakers fail to reach an agreement?
Extended shutdown would put soft landing at risk
While we weathered one of these back in 2019, experts consider that more of a “partial” shutdown, because a number of government agencies had secured full-year funding ahead of time and were relatively unaffected. This time around, the prospect of a shutdown is more threatening, as with no agencies funded, businesses would be subject to serious disruptions, from a halt in regulatory approvals to potential payment delays—not to mention a possible lapse in reporting by the government of data on the US economy we see as crucial to gauging the Fed’s policy trajectory. Goldman Sachs, trying to put a number to these risks, estimated that each week of a government shutdown could erode fourth-quarter growth by up to 0.15% percentage points, which rises to 0.20% per week once private sector effects are included. The longer such interruptions last, the more tenuous becomes the case for a soft landing.
More disruption is the last thing the bond market needs
In the meantime, fears over an increasingly dysfunctional US government only add to pressure on the bond market. That stress is finally starting to show up in credit spreads with the gap between 30-year federal agency bond yields and corresponding 30-year US Treasuries peaking. Along those lines, we have also witnessed a surge in five-year US dollar-based credit default swap protection since the start of the year, from 20 to 40 bps. On the supply side, as we’ve discussed before, fiscal policy keeping the economy afloat amidst a pandemic and the Fed’s campaign of rate hikes has resulted in a ballooning budget deficit and a climbing pile of debt (see below), with nearly $2 trillion in additional debt issuance planned for later this year. Concerns over such fiscal trends, a loss of confidence in the capacity of the government to manage the nation and its budget—a perception not helped by Republicans’ historic move to oust their own House Speaker—along with the Fed’s plan to shrink its balance sheet have combined to soften demand for Treasuries. We see these pressures continuing to exert a negative effect on longer-duration assets over the near to medium term, with plenty of risk for further disruptions, political and otherwise.
Top brands suffer reversal in Q3
While strong jobs data may tell us something about households’ capacity to spend, it’s also interesting to look at data on where consumers are spending. For most of 2023, despite rising interest rates in the US and challenging economic conditions in Europe and China, there was apparently big demand in the global luxury goods market. Consumers’ appetite for premium goods certainly showed up in the S&P Global Luxury Index, a basket of stocks representing the world’s 80 largest luxury brands, which rallied throughout the first half of the year. Bernard Arnault, the chairman and CEO of the biggest of those firms, LVMH, saw his net worth surge to a staggering US$180 billion, briefly making him the world’s richest man. That trend reversed in Q3, however, and the sector sold off (see below), as spending on luxury goods began to soften, with Bank of America reporting a 16% year-over-year drop in US luxury spending during the third quarter.
Recessions spell trouble for luxury firms
Of course, it was fairly inevitable that rising input costs along with higher interest rates in the West, depleting pandemic savings, and subdued demand from China would weigh on luxury goods purveyors. Premium brands have held out for some time, surely in part because their remarkable pricing power enhances their ability to pass rising costs onto customers. We seem to have finally hit an inflection point, as recent data point to so-called “aspirational consumers”—those purchasing entry-level luxury products—cutting down on their spending, putting a dent in growth even while high-net-worth individuals continue to shell out on the highest-price goods. To the extent economic conditions surprise to the downside, the luxury sector seems particularly exposed. As the graph above suggests, while big drawdowns in luxury firms don’t always predict a recession, the sector tends to suffer greatly when a downturn has commenced.