Equity markets continue to stall under the weight of higher interest rates. Since the 10-year Treasury bond yield surpassed 4% on August 1, the S&P 500 has lost just over 3.6%. More notably, there has been a change in the leadership sectors. Technology and Communications have been the undisputed leaders in 2023. However, the Energy sector has outperformed them by 6.9% and 5.7% respectively since the beginning of the month. A stronger-than-expected economy is improving the near-term outlook for oil and gas. At the same time, higher Treasury yields are increasing the discount rate for stocks whose valuations are tied to earnings prospects further off in the future. Even blowout earnings numbers from artificial intelligence titan Nvidia were not enough to overcome the pressure of higher rates on stretched Tech and Communications multiples.
Considering inflation‘s lower trajectory, the move higher in long-term Treasury yields has caught many by surprise. Long-term yields typically correlate with inflation expectations. Instead, the recent surge has been driven by a flood of supply. Over recent weeks, key holders of U.S. Treasury bonds have been net sellers with Fitch’s U.S. credit downgrade being the likely catalyst. It is early, but we are seeing indications of the bond market pushing back on an increasingly bleak U.S. fiscal outlook.
Higher interest rates matter. For one, they increase the competition for capital. With the S&P 500 trading at a 5.2% earnings yield and the 10-year U.S. Treasury yield at 4.25%, the spread over the "risk-free" rate is at its narrowest since the Great Financial Crisis. In other words, bonds are starting to offer a compelling alternative to stocks. Thus, equity earnings are discounted to a greater extent. Higher rates also increase companies’ funding costs. For the most part, S&P 500 balance sheets are in good shape. Net interest cost as a percentage of outstanding debt is near a multi-decade low and roughly half of the outstanding debt matures after 2030. Nonetheless, we have an eye out for vulnerabilities. Banks, for example, are not on as strong of footing.
With the pressure of interest rates mounting, stock picking will be critical. Pushing earnings multiples much higher from their current levels will be difficult. It will be important to isolate those with viable earnings growth strategies from those with the mere hope of it. To that end, we continue to favor companies that are DEEP (Domestic, Essential, Energy Immune, Pricing Power). Companies with such characteristics are best positioned for fundamental outperformance.
Preston May, CBE®
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S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.