Acknowledging the Few

With interest rates surging, stocks have faltered through September. Last month, U.S. 10-year Treasury bond yields broke above 4.5%, while the S&P 500 lost 5.5%. Inflation plus a wave of Treasury bond issuance and a sudden lack of big buyers are pressuring rates. Because cash and bonds are viable alternatives, investors are finding it increasingly difficult for stocks to make progress. A select group of stocks continues to attract capital, but that list is growing shorter by the day.

Since the start of the year, the U.S. 10-year Treasury yield has risen over 70 basis points. Long-term inflation expectations have increased at the margin, but the main driver of higher rates has been growing concern about a flood of supply. With the U.S. staring down a wall of maturing debt, a rising entitlements burden, and interest costs, the issuance of Treasuries is expected to increase substantially in the years ahead to fund these obligations. At the same time, the traditional Treasury buyers have largely subsided. Holdings at the Federal Reserve, commercial banks, China, and Japan are all in decline. Rates are likely to be higher for longer.

Inflation also continues to be a pest for the Fed. Core inflation measures are falling, but high-profile union negotiations — such as the United Auto Workers strike against General Motors, Ford, and Stellantis — and a resurgence of energy prices have the Fed on their toes. Despite calls to halt or even reverse some of their rate hikes, Fed officials look likely to press on with at least one more increase. In their eyes, the long-term consequences of inflation are greater than that of a recession. The problem is that the primary source of inflation is well beyond the Fed’s control. As Fed officials press on, consumers, banks, and weaker businesses are vulnerable.

With high rates, stubborn inflation, and the looming threat of recession, we expect only a narrow group of stocks will perform well. To be appealing relative to bonds, a stock must have a clear and realistic growth trajectory. Those with organic growth strategies that are mostly immune to outside influences are best positioned. Our focus remains on the elite companies that can dependably increase their dividends at a high rate regardless of the economic uncertainty.

Thanks,
Preston May, CBE®
Research Analyst