Record Highs Despite Higher Long-Term Interest Rates
The S&P 500 index reached new highs this month as economic data continued to positively surprise. Recall, the August pullback was primarily caused by recession worries from weak payroll data. These worries have since been alleviated by a series of better-than-expected economic data suggesting the labor market remains strong, and consumer spending remains robust. Taken with the Fed’s pivot towards easing last month, the conditions were ripe for a rally in stocks.
For the fixed income market and in particular longer duration bonds, a stronger economy meant longer-dated interest rates needed to increase. As shown in the graph below, as positive economic surprises increased so did the US 10Yr Treasury bond yield, which increased substantially from 3.6% on the day of the Fed’s rate cut to 4.2%. Rates are now back to July levels, which was before the August growth scare noted above.
There are likely other contributing factors driving up long-term interest rates, including the growing probability of a Trump victory. Betting site PredictIt now estimates that Trump has a 59% chance of winning the election (see graph below). As Trump’s chances have increased, so have longer-term interest rates. Some have dubbed the rise in Treasury yields as part of a “Trump trade”. The implication is that long-term interest rates will be higher under a Trump presidency because he is likely to run a higher deficit, and his tariff policies could increase inflation. Both outcomes would likely increase the term premium and, therefore, longer-term interest rates.
According to the Penn Wharton Budget Model’s assessment of the Trump campaign’s proposed tax and spending proposals, the Trump proposals would increase primary deficits by $5.8 trillion over the next 10 years[1]. With potentially higher funding needs, the market may be anticipating that higher yields may be necessary to attract investor money to the Treasury market in future years. Notably, this analysis excludes any offset from any revenue increases from new tariffs that the Trump campaign has also proposed. (And, it does not appear to include any potential cost cutting programs.)
Although the details are unspecified, the Trump campaign has said it will consider a 10% across the board tariff on all imports and in certain cases much higher tariffs. President Trump recently declared at the Economic Club of Chicago that “tariff” is his favorite word.[2] One can only conjecture as to whether his comment is merely bluster but given his previous use of tariffs one should presume that more are on the way. The Penn Wharton Budget Model believes that “new import taxes and tariffs could raise several trillion dollars in new revenue over the next decade[3].
Some of the upward move in long-term interest rates may also be driven by the widely held view by economists that tariffs are inflationary. In practice, tariffs are charged on targeted goods at the port of entry, much like a sales tax to the supplier. That tax may be in whole or in part passed along to the end consumer – this would increase inflation. In a paper published by several Federal Reserve economists that examined the price impact of the Trump Administration’s 2018 tariffs, they found that the “…tariff changes have been almost entirely passed through into domestic prices…”[4] This finding would support an argument for a higher term premium and therefore higher longer-term interest rates under a higher tariff regime.
The reality may differ from current expectations. There has not been a broad-based tariff ever implemented in today’s modern, global economy. We would further add that increasing tariffs at a time when Core Goods prices have been in decline could potentially limit the ability of suppliers to pass through higher prices to the consumer, thereby dampening any inflationary impact. Time will tell and longer-term interest rates will adjust accordingly.
Market Outlook
It is easy to be overwhelmed by the constant election chatter and to overthink the election’s importance on the financial markets. Well positioned portfolios can weather near-term election driven volatility. For historical perspective, the market rallied after both the hotly contested 2016 and 2020 elections. It even rallied after the contentious “hanging chad” election of 2000. Why? Because the U.S. economy is so vast and so dynamic that so long as the rule of law still exists, the businesses that comprise the economy will adjust and find ways to grow.
Reflecting on the extraordinary recent surge in inflation and interest rates, the economy’s resilience is remarkable. Companies had to run through a gauntlet of challenges during the last few years. As Nietzsche is attributed to saying, “Whatever doesn’t kill you makes you stronger.”[5] Battle hardened, these companies provide a robust base for continued economic growth even during times of uncertainty.
Furthermore, the “Fed Put” is back. (Check out our recent webinar on this topic.) The importance of the Fed’s recent pivot to easing should not be overlooked. With inflation largely conquered, the Fed is now more concerned that they have held interest rates too high for too long. The Fed is on watch for economic weakness and has expressed its intent to use its ability to inject massive liquidity into the financial system as a powerful backstop should it occur.
Similar to our comments last month, we continue to lean risk-on. In the short run, there are some stretched stock valuations, so a pullback is always a possibility, but there are also opportunities to own previously overlooked stocks. From a long-term perspective, we are comfortable with our secular themes and look to add on dips. And we are likely not the only investors looking to buy dips. There is a record-breaking $6.5 trillion of assets parked in money market funds, according to the Investment Company Institute. As the Fed lowers the Fed Funds rate over time, these funds will likely find their way into both stocks and bonds.
Conclusion
The stock market has set record after record this year. It has done so by climbing a wall of worries. First, inflation. Then, fears of a weakening economy. Eventually, the economy will fall into recession but betting on that has been a fool’s errand during the last two years. It is also generally a bad idea to try to trade around events like elections as those strategies often backfire. We invest for the long-term wealth creation using a disciplined, established investment process. A process that has stood the test of time and will continue to serve clients’ long-term financial goals whatever the future brings.
Disclosures
LIM is an Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-dominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass throughs), asset-backed securities and commercial mortgage-backed securities.
The S&P 500 Equal Weighted Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500 index, but each company is allocated the same fixed weight at each quarterly rebalance.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 Index total market capitalization.