What a difference a week makes! Bond yields fell sharply on a relatively benign (compared to expectations at least) quarterly refunding plan from the US Treasury, a somewhat dovish-sounding Jerome Powell (again, relative to expectations) at the November FOMC meeting, and a monthly jobs report that saw lower-than-expected nonfarm payrolls and wage gains, as well as a tick higher in unemployment.
After very briefly trading above 5% intraday on October 23rd, 10y Treasury yields had fallen more than 40bp by the end of last week, with 30y yields lower by a similar amount. Meanwhile, futures markets had all but eliminated any expectations of an additional 25bp rate hike before the inevitable long pause, with odds settling at around 5% for the December meeting and topping out at 10% in January of 2024.
The abrupt fall in rates eased some of the recent pressure on P/E multiples. US equities surged 5+% on the week, with most benchmarks finishing higher every single day. Rate-sensitive sectors were the biggest beneficiaries, including real estate and longer-duration growth stocks. International stocks were better as well, but to a slightly lesser degree than domestics.
Behind the scenes amidst all of the recent rates-driven price volatility, Q3 earnings season has been coming in slightly better than expected. By the end of the week, 81% of the companies in the S&P 500 had reported Q3 numbers, with a blended earnings growth rate of +3.7% y/y, on revenue growth of +2.3% y/y plus 40bp of margin expansion to an average net margin of 12.0%. The pivot to earnings growth follows three consequence quarters were earnings for the S&P 500 were lower on a y/y basis.
Albion’s “Four Pillars”:
Economy & Earnings
The US economy has shown resilience so far in 2023, and Wall Street analysts expect full-year corporate earnings to be roughly flat y/y. Albion’s base case expectation is that the US economy will enter recession in late 2023 / early 2024, putting downside pressure on earnings.
The S&P 500’s forward P/E of 18x is above the long run average, so valuation could be a headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Eq Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the mid single digits.
Rates rose dramatically in 2022 due to a sharp pivot in monetary policy, and have remained elevated in 2023 as the Fed remains committed to fighting inflation. Futures markets now imply only a 10% chance of another 25bp rate hike in late 2023 / early 2024, followed by a pause.
After reaching 40yr highs in spring of 2022, inflation has moderated somewhat over the past 18 months. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged.