26 Oct Bridge Perspective – October 2023
Source: Morningstar Direct
As referenced in table 1, Quarter 3 saw a cooldown in global indices outside of the energy markets. This marked a reversal from the first half of the year where the NASDAQ was up over 30% due to AI craze that propelled markets into an upwards frenzy. The main reason for the slowdown was due to the domino effect caused by the rise in energy prices, which in turn altered the expected path of inflation and, consequently, interest rates.
The Federal Reserve has been raising rates over the past 18 months to curb inflationary pressures and bring year-over-year inflation down to the Fed’s 2% mandate. They have been attempting to achieve this by raising the federal funds rate, a short-term interest rate that commercial banks charge each other for overnight excess reserve lending. This interest rate serves as the gravitational force for all other interest rates in the economy. When it changes, the interest rates with the maturities closest to it change in a similar fashion, with each successive rate being less correlated to it. This partially explains why longer-term rates could be lower than shorter-term rates when the Fed raises rates quickly, gravity simply hasn’t caught up to the longer-term rates yet.
During the first half of the year, year-over-year inflation rates (as measured by CPI) moved closer to the Fed’s 2% target.[Chart 1] There was the hope that the Fed would start cutting rates at the end of 2023, even though they made it clear they would not be cutting rates. However, with energy prices spiking again during Q3 (the first domino), inflation has begun to reverse course (the second domino).
This has altered expectations for the path of interest rates because the Fed has been raising interest rates specifically to combat inflation. This has contributed to the upward shift of the yield curve (short rates higher for longer), as per the Unbiased Expectations Theory, where longer-duration rates can be seen as an expectation of future spot rates.[Chart 2] In simpler terms, if market participants anticipate that the Fed will maintain higher short-term rates for an extended period, then long-term interest rates are expected to increase. In more straightforward language, there must be an incentive for investors to lock up their money in longer-duration fixed income securities. If the Fed signals that short term rates will be higher for an extended period, long-term rates need to rise to compensate investors for the reduced liquidity.
Source: Authors Calculations
Source: U.S. Department of the Treasury
Unfortunately for equity markets, higher rates for an extended period have a detrimental impact on equities in two ways. First, there is still a risk of a ‘hard landing’ in the economy, where it cannot endure the higher rates, leading to bankruptcies, unemployment, and ultimately a recession. Second, even without a hard landing, higher interest rates diminish equity valuations because the present value of future cash flows becomes smaller when discounted at a higher interest rate. This asymmetrically affects stocks with high valuations because their cash flows are expected to be further out in the future than stocks with lower valuations. Higher interest rates also exert pressure on equity valuations for the same supply-demand reason as with fixed income. Investors need an incentive to allocate their funds to equities when they can earn 5% on their cash, which reduces the valuation of equities to make their earnings yield more attractive. This trade-off between cash and other asset classes was not present during the previous decade and was one of the reasons that risky assets saw record capital inflows during the end of the low interest rate period.
This causal link that has emerged between energy markets, inflation, interest rates and equity markets can be observed by the change in the correlation between the SP500 daily returns and the WTI spot crude oil daily changes. According to the author’s calculations, from 2013 to 2020 the correlation of the daily returns between the SP500 and the daily oil price changes was 0.266, which shows a low positive correlation. However, in Q3 of 2023, the correlation between the two markets was only 0.034 and for the month of September it was -0.09. This shows that the relationship between the equity markets and energy markets has fundamentally changed. The connecting link between the two is inflationary pressures. The reason why inflationary pressures matter for the equity markets is the Fed’s decision-making regarding interest rates.
In this inflationary environment, any asset that poses a risk of driving inflation into the broader economy should have a lower correlation with equity markets compared to its historical average, primarily due to the interaction with interest rates. This is because when the value of that asset increases, the markets interpret it as a sign of potential future inflation, leading to higher interest rates over an extended period, which has a negative impact on both equity and bond markets in the present moment. This is why research has shown that equities and bonds tend to exhibit a more positive correlation during high inflationary periods than during low inflationary periods. That’s also why including an inflationary asset in your portfolio can serve as an effective hedge.
In this dynamic market environment, it is essential to maintain a diversified portfolio that seeks to capitalize on the evolving marketplace. Here at Bridge Advisory, LLC, we vigilantly monitor market movements with an analytical perspective to protect your assets. If you have any questions, comments, or concerns, please don’t hesitate to schedule a meeting with your respective advisor. We are here to assist you!
NOTES AND DATA SOURCES
- The AI craze drove investors to pour a record $8.5 billion into tech funds last week, Bank of America says (yahoo.com)
- The Federal Reserve’s Dual Mandate – Federal Reserve Bank of Chicago (chicagofed.org)
- What Is The Federal Funds Rate? – Forbes Advisor
- US Federal Reserve unlikely to cut interest rates in 2023 | World Economic Forum (weforum.org)
- Theories of the Term Structure of Interest Rates – Breaking Down Finance
- What is a soft landing? | Brookings
- Inflows into equity funds smash records (ft.com)
- Understanding the correlation of equity and bond returns | Macrosynergy Research
- A Deep History of the Bond-Equity Relationship and Inflation – MSCI
- Federal Reserve Economic Data | FRED | St. Louis Fed (stlouisfed.org)
- Interest Rate Statistics | U.S. Department of the Treasury
Bridge Advisory LLC Disclosures
Bridge Advisory, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Investment Advisory Services offered through Bridge Advisory, LLC. Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type. Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio. Information herein has been obtained from sources believed to be reliable, but Bridge Advisory, LLC. does not warrant its completeness or accuracy; opinions and estimates constitute our judgment as of this date and are subject to change without notice. This newsletter expresses the views of the authors as of the date indicated and such views are subject to change without notice.